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Allegheny Technologies Incorporated (NYSE:ATI)

Q3 2008 Earnings Call

October 22, 2008 1:00 pm ET

Executives

Dan L. Greenfield - Director of Investor Relations and Corporate Communication

L. Patrick Hassey - Chairman, President and Chief Executive Officer

Richard J. Harshman - Executive Vice President, Finance and Chief Financial Officer

Analysts

Michael Gambardella - J.P. Morgan

Peter Jacobs - Ragen MacKenzie

Kuni Chen - Banc of America Securities

[John Tomaso] - Private Investor

Gautam Khanna - Cowen and Company

David Lipschitz - Merrill Lynch

Luke Folta - Longbow Research

Mark Parr - KeyBanc Capital Markets

Sal Tharani - Goldman Sachs

Sanil Daptardar - Sentinel Asset Management

Lloyd O'Carroll - Davenport & Company, LLC

Operator

Good day, ladies and gentlemen, and welcome to the third quarter 2008 Allegheny Technologies Incorporated earnings conference call. My name is [Fab] and I'll be your coordinator for today. (Operator Instructions)

I would now like to turn the presentation over to your host for today's call, Dan Greenfield, Director of Investor Relations. Please proceed.

Dan L. Greenfield

Thank you, Fab. Good afternoon and welcome to Allegheny Technologies earnings conference call for the third quarter 2008. This conference call is being broadcast live on our website at AlleghenyTechnologies.com and on CCBN.com. Members of the media have been invited to listen to this call.

Participating in the conference call today are Pat Hassey, Chairman, President and Chief Executive Officer, and Rich Harshman, Executive Vice President, Finance and Chief Financial Officer.

After some initial comments, we will ask for questions. During the question-and-answer session, please limit yourself to two questions to be considerate of others on the line.

Please note that all forward-looking statements made this afternoon are subject to various assumptions and caveats as noted in the earnings release. Actual results may differ materially.

Here is Pat Hassey.

L. Patrick Hassey

Thanks, Dan, and thanks to everyone for joining us today. We had a solid quarter in a period of uncertainty. We demonstrated strong cash flow and we have a solid balance sheet.

Return on capital employed was 22%. Excluding our capital projects currently under construction, return on capital employed was 26%.

Return on stockholders equity was over 27%.

Net debt to total capitalization was 9.3%.

Gross cost reductions totaled nearly $104 million for the nine months. We remain focused on reducing costs to systematically improve operating efficiency.

We had $273 million of cash on hand at the end of the third quarter. This is after our self-funded investments during the first nine months of 2008. We had $185 million increase in managed working capital, year-to-date capital investments totaled $365 million, and we spent $242 million to repurchase shares of ATI stock. We are not accumulating cash as we expect strong cash flow to continue in the fourth quarter, managed working capital was reduced by over $86 million in the third quarter compared to the second quarter, and we expect a significant reduction in working capital in the fourth quarter.

Finally, we have no borrowings under our $400 million credit facility, so let's get right into our view of the markets.

Some of our markets are strong, while others are weak due to the credit issues and a slowing global economy. There is also short-term uncertainty in the aerospace supply chain. Aerospace and Defense accounted for 28% of our year-to-date sales. There's a strike at Boeing, and their 787 program is delayed.

While our third quarter performance in Aerospace was good, we are now in a period of increasing short-term uncertainty. First tier customers are hesitant to make forward purchases due to the strike. We are encouraged that the parties are returning to the table and hopeful that a resolution to the strike can be achieved soon.

Order backlogs at our Airframe and Jet Engine customers remain at high levels. Our long-term strong growth view of this market has not changed. Expected new or additional growth for Commercial Aerospace has been pushed out, for how long depends upon the resolution of the Boeing strike and the successful flight and production ramp of the 787.

Even with the uncertainty in the Aerospace supply chain, total ATI shipments of our titanium products increased to 12.5 million pounds or by over 19% in the third quarter 2008 compared to last year's quarter. In short, we stayed on scheduled growth.

We have moved our titanium units to non-Aerospace markets. ATI, along with our titanium joint venture, is now a leading supplier to the industrial titanium markets, which include chemical processing, oil and gas, electrical energy, desalinization, and architectural applications.

For the first nine months, ATI shipped over 36 million pounds of titanium products. We expect to reach 48 million pounds of total titanium shipments in 2008. This would represent growth of 17.5% over 2007. We believe our 2009 titanium product shipments will be essentially flat, with that expected to be achieved this year, or in the 45 to 50 million pound range as in 2008.

You have heard me say that ATI is flexible and that we can move our metallic units to changing markets and to new markets for ATI. One such target market is defense armor. Why would we choose this market? Because the global market is very large, it needs our titanium and specialty alloys, and it's a new market for ATI.

Our recently launched market sector team, ATI Defense, is making good progress through business development. It is introducing new titanium and specialty alloys and alloy systems. Global customer inquiry volume continues to grow. Trial and production orders are being books with new ATI customers each month. The defense hardware market for our specialty metals is also strong and growing.

The chemical process industry and oil and gas accounted for 23% of year-to-date 2008 sales. This is the largest market for our zirconium alloy and for our flat rolled products. The market is being driven by global growth to make a better world and to feed the growing population. Demand has been so strong for our industrial grade zirconium that we are adding capacity. Prices are increasing and supply is tight.

The global oil and gas market still looks strong.

Electrical Energy accounted for 16% of year-to-date 2008 sales. Strong global market conditions and extended prospects for our grain-oriented electrical steel are expected to continue. We expect to sell 120,000 tons of grain-oriented electrical steel next year, which is our annual capacity for this product.

Demand is solid for our nickel-based alloys from the industrial gas turbine market.

Now turning to the alternative energy markets, demand for our castings for wind energy applications is robust. We are hearing concern about credit availability from one of our wind energy customers. While not a trend, we will continue to watch this closely.

We believe that solar energy could be a big new market for our stainless steel plate and precision rolled strip products.

Thirdly, demand from the geothermal market is expected to continue to grow.

Very importantly, we are beginning to see the nuclear energy renaissance. We are seeing increased inquiries from this market. A recent team leader was named for our ATI nuclear energy market sector team. For the last 50 years ATI has been a leading supplier of the many specialty metals from zirconium hafnium to titanium and other specialty alloys required for nuclear power plants. No other company brings such a range of specialty metals to the nuclear energy market.

Direct International Sales were a record $400 million or 29% of sales in the third quarter 2008. Our strategy is to continue to diversify and differentiate ATI in key global markets. We see both near-term and long-term growth opportunities in Asia as well as Europe. We target markets in these regions that need our specialty metals. We recently added to our sales and marketing presence in Eastern Europe and also in the Middle East. There are areas of the world that we believe have a lot of potential for us.

Aerospace and Defense plus the infrastructure markets and the medical market have been driving ATI's performance. These markets accounted for 70% of sales in the nine months of 2008. We continue to believe in the long-term prospects of these markets.

An interesting point before we move on to another topic. ATI sales in 2008 remained stable even while raw material indices and surcharges have decreased significantly. We have focused on profitable growth through penetration of our existing markets, new markets and volume growth. In other words, our operating companies and market sector teams have successfully found customers for our specialty metals.

We continue to make progress on our capital investments, which better position ATI for long-term growth. In June we commissioned our upgraded specialty and titanium plate facility in Western Pennsylvania. Our premium titanium sponge facility in Utah is on a revised schedule to be in production during the second quarter of 2009. Our titanium and superalloy forging facility in North Carolina remains on schedule and is expected to begin operations in the third quarter of 2009. The expansion of our precision rolled strip joint venture facility in China is expected to be fully operational in the first quarter of 2009.

In September we announced that our Board of Directors had approved, subject to satisfactory resolution of certain open issues, a new hot rolling and processing facility in our Flat Roll Products segment. This project is necessary and the returns are very good. Progress is being made in resolving the open issues. We expect to begin construction of this project some time in 2009. Major expenditures are not expected until 2010 and 11, which is after our Utah and North Carolina projects are completed.

ATI has grown and been transformed without the use of leverage. We deploy our strong cash flow with a balanced approach to create long-term value for our shareholders. We are committed to this philosophy and can adjust the timing of our self-funded capital projects accordingly.

Now turning to our fourth quarter outlook, we expect volumes to be down and pricing to be competitive for most of our products in the fourth quarter. The exceptions are grain-oriented electrical steel and our exotic alloys. Demand is weak for our standard stainless steel sheet and plate products. In fact, the global stainless market in total we would classify as anemic. With the exception of oil and gas, most markets are soft. Housing, appliance and automotive are particularly weak.

Service center inventories were low in the third quarter. Industry reports put the inventory level at three months in September. Inventory levels could even trend lower in the fourth quarter as some customers take actions to avoid raw material risk.

Even in this weak market we expect to ship approximately 300,000 tons of standard stainless products this year. This is at the low end of our targeted range and base prices are also very low.

Of note, even though demand for our stainless products is weak, our Flat Rolled Products segment was nicely profitable in the third quarter 2008, and we expect this segment to be nicely profitable going forward. This segment continues to benefit from an ongoing transformation. Product, market, geographic diversification and costs have been greatly improved in this business.

Now, let me summarize where we are. First, we had another solid quarter in a very challenging economic environment.

Two, our cash flow is strong and continues to fund our growth investments and our share repurchases.

Three, our financial position is strong. Our balance sheet is solid and we have no borrowings under our $400 million credit facility.

Four, we are diversified, global and we have the ability to move our metallic units to changing global markets.

Five, the global credit crisis has created an environment of uncertainty, particularly in the last few months.

Six, ATI is more resilient to economic downturns than at any time in our history, yet we are not immune to the economic outfall of the global credit crisis.

Seven, there's an ongoing strike at Boeing and their 787 program has been delayed. This is creating short-term uncertainty in the Aerospace supply chain for both airframe and aero-engine related products.

Eight, as a result of this, we expect fourth quarter volumes to be down somewhat. Pricing remains very competitive for most of these products. We now expect fourth quarter earnings to be in the range of $1 to $1.10 per share. This would result in 2008 earnings of between $5.51 a share to $6.51 a share - $5.61 a share.

We expect 2009 to present a challenging but manageable environment. We are proactively adjusting the production levels of some of our products and ratcheting up our 2009 cost reduction programs to meet this challenging economic environment.

Lastly, we will continue to manage this company for solid earnings and strong cash flow.

With that, we'll now open the earnings call for questions. Operator, may we have the first question?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Gambardella - J.P. Morgan.

Michael Gambardella - J.P. Morgan

In your guidance that you gave for next quarter, what is the LIFO assumption in that guidance?

L. Patrick Hassey

I'm going to let Rich take that one, Mike, and I think I'll add anything if it's not fully covered from my standpoint.

Richard J. Harshman

Yes, Mike, well I think at this point the LIFO assumption reflects the assumptions we made that drove the LIFO benefit here in the third quarter. Obviously, the visibility that we have into a wide variety of the raw material costs is no greater than probably your visibility. I don't think anybody would have predicted that nickel would be where it is today. I think that that remains potentially volatile as we move through the quarter. I think we're seeing the same things, quite frankly, in chrome and in moly and in titanium scrap and nickel bearing scraps as well.

So the assumptions we made at the third quarter, the guidance we have is consistent with that, and we'll just have to see where it all ends up.

Michael Gambardella - J.P. Morgan

But in terms of a dollar amount in your guidance there for the quarter?

Richard J. Harshman

Yes, I'd rather not get into identifying specific assumptions we make on each individual raw material element because they change, quite frankly, as we move through the quarter, and it all depends upon what the mix is in our inventories as well. So I'd rather not get into the specific assumptions we're making on an element-by-element basis.

Michael Gambardella - J.P. Morgan

Can you say if the LIFO credit is bigger or smaller than it was in the third quarter?

Richard J. Harshman

I think it's potentially in a range that might be a little bit smaller to something that might be similar.

L. Patrick Hassey

Mike, just a note. We've read some people's comments around the third quarter. Let me just add this to those comments around LIFO.

As we go through the third quarter and we had this rapidly decreasing raw material price index for elements going into all of our products, we had higher priced materials running through the quarter. And so we have a negative affect and a margin compression on all of our products because of the higher material costs for the material that is in process and closing out and selling at lower prices.

That is mitigated by the LIFO reserve benefits that we received at the end of the quarter so, from my standpoint, when I read somebody telling me that we had LIFO profits and that affected the quarter, the earnings in the quarter are pretty solid when you subtract from that quarter the compression from the material that was more expensive going into the period and then mitigated by the LIFO reserve plusses at the end of the period. Those are solid earnings, clean earnings in the third quarter.

Michael Gambardella - J.P. Morgan

My second question, Rich, can you give us a feel for what inventories were at the end of the quarter compared to the last quarter?

Richard J. Harshman

Inventories by a dollar amount compared to last period, most of the $86 million reduction in managed working capital at third quarter and compared to second quarter was in inventory.

Michael Gambardella - J.P. Morgan

Are you seeing any of your - this is an inventory question - are you seeing any of your customers in this kind of credit squeeze starting to rely on you a little bit more for credit?

Richard J. Harshman

Yes, I think that's really a good question. I'll answer it two ways. One, on the receivables side I would say no, primarily because we don't allow that. We're not a bank. And we're not seeing any deterioration in our aging of receivables and our days sales outstanding or anything like that.

We've got good credit groups in the operating companies and they help the operating company management make good business decisions in the area of credit and the level of risk that we accept from a credit limit on a customer-by-customer basis.

I think on the inventory, especially in the standard grade stainless steels, I think you have seen, quite frankly, for most of this year a move on the part of the mills to have higher levels of ready coil inventory that result in quick response time to the customers, especially on the distribution side. And that's why you see the number of months' inventory at the distributors being lower, because that risk essentially has shifted from a raw materials standpoint from the service centers as distribution customers back to the mills.

And that is consistent with, you know, the point Pat made about the focusing on LIFO versus FIFO, the fact of the matter is, we're on LIFO. And I'd rather be on LIFO, both in periods of rapid inflation and deflation on the raw material costs that we're seeing today, because what we're seeing is the margin compression that Pat pointed. For example, on ready coil, if we've held onto this ready coil for a couple of months, we melted it at a higher cost than what the surcharge mechanism is and LIFO serves to mitigate that somewhat - not completely, but somewhat - from the standpoint of earnings.

So that will continue in the fourth quarter, quite frankly.

L. Patrick Hassey

And Mike, what we see is it's a plus and a minus game here. It's a minus game that the mills are forced to sell their standard products out of ready coil. That's not the function of a mill. It should be the function of the distribution community. But with these falling nickel prices and chrome prices, basically, that's not the case today.

The good news side of that is it makes it very difficult for imports to come into the country under some type of a pricing scheme that puts them out 8, 9, 12 weeks and have the distributors think that that's a good deal, to buy those versus buying out of mill depos.

So it's a two-edged sword, one part we like, one part we don’t like.

Operator

Your next question comes from Peter Jacobs - Ragen MacKenzie.

Peter Jacobs - Ragen MacKenzie

First, what do you see in terms of products being shipped into the Boeing supply chain? Have any of your Tier 1 customers or Boeing directly, has anybody out there started to cut back on the product that they're taking due to the work stoppage?

L. Patrick Hassey

I think that's fair. I think when you look at the Tier 1 suppliers there's two things that I think are coming out of this. Those areas where Boeing needs to build the supply chain up to begin or ramp up more production for the 787 still seems to be flowing from a raw materials standpoint. But as you get to components or you get to semi-finished components, where somebody is actually making an assembly that's going to go into that aircraft, I think that you're starting to see those particular lanes to Boeing plugging up.

Just stepping back to explain that, you can only have so many parts in the chair for Boeing to assemble. You can only have so many jet engines ahead of the airframe build. And so the longer that the strike - and my own prediction was after 45 days or word is right now you're going to see more of this supply chain clogging up and it will have an affect on all of the Boeing suppliers and materials suppliers, which is part of the reason that we see the fourth quarter at lower shipping volumes. So this thing certainly has an impact to the whole industry.

Peter Jacobs - Ragen MacKenzie

So in the third quarter did you see an impact or not, and in the fourth quarter, how much of an impact are you basically assuming in the guidance that you gave?

L. Patrick Hassey

Well, I'm not going to get into the exact details of where we're shipping to Boeing, where we're not shipping. In our particular contract we have minimums in these programs. And those minimums certainly are moving to the customer, and that customer then can put those inventories in a warehouse or he can put them out to his vendors to fabricate.

So we're seeing some reduced shipments there and we're seeing customers that are periphery to that that make parts, make final components and assemblies, pushing back, and so it does affect our other core business ultimately on the jet engine side. It doesn't affect spare parts. It doesn't affect the airbus programs. It doesn't affect the military programs. It doesn't affect the private jet programs. But it does affect what Boeing does, putting out their 40 airplanes a month.

Peter Jacobs - Ragen MacKenzie

And then my second question is related to the capital spending and the strategic investments that were announced mid-September. Now, the world's changed considerably over the past month, at leas the outlook for the world. Does that change your thinking about the spending that you may incur in the context of perhaps lower earnings levels in the next couple years and lower cash flow generation?

L. Patrick Hassey

Well, we always have the opportunity to extend or move these programs around based on the cash that we have available.

So, first of all, the purpose of the program. The purpose of the program is for the long-term profitability and growth of this company. These are assets that we're putting in place not only for stainless steel, if that's what people are thinking about slowing down. These are assets that make specialty metals. It makes titanium plates. It makes zirconium plates. It makes specialty and nickel steel. It's an asset base that would give us capabilities beyond anything that exists in the world today. So it gives us a competitive advantage. It gives us a cost advantage. It enters us into market sizes and alloys that we cannot make today.

So for the long-term benefit of the company and for the shareholders growth, this program needs to go forward.

As we move into 2009, the first parts of these programs are the finishing up of the engineering of this, the preparation of the site and the ordering of the long-term lead items. So the major expenditure year is not 2009. The major expenditure year is the construction of this line in 2010 and 11.

As we go through this, we have looked at all different kinds of scenarios, schedules, extensions and abilities to fund this on an internal basis, and it is our plan to fund this with internal cash flow to build these assets and at the same time have free cash flow for other balanced items in the company. That means paying dividends. That means, if we have a share buyback program, funding the share buyback program. That means keeping our balance sheet flexible for acquisitions.

So basically that's a long answer, but it's the real answer.

Peter Jacobs - Ragen MacKenzie

Well, it gets to the heart of the question and that is that it sounds like you're less likely to lever up the balance sheet to get this done. Is that correct?

L. Patrick Hassey

We have no intention to lever the balance sheet to get this done.

Operator

Your next question comes from Kuni Chen - Banc of America Securities.

Kuni Chen - Banc of America Securities

Just a question on the titanium side. As far as your contracts go with Aerospace customers, has there been any discussion about renegotiating some of these long-term contracts given the impact of delays and push outs and whatnot? And is your view that a contract is a contract and you're going to stick to that and, if there isn't an attempt to renegotiate or open up some of these contracts, will you take people to court.

L. Patrick Hassey

Kuni, that's a very interesting question, but let me give you the basic answer. There's two types of contracts - one is a requirements contract, and one is a contract where we have major capital investments going in and it's a take or pay contract with minimums and targets and so forth.

So for the contracts that we have minimums, take or pay, that are negotiated, there's no change in those contracts.

When we have a requirements contract, obviously that requirements contract moves with the market. If somebody's making 10 units, we're going to get the business for our share of the 10 units. If they're making 20 units, we're going to get our share of the business for the 20 units, and we understand that and we move with those kind of requirements.

All of our contracts have material sides to them and conversion sides to them so, as the material costs come down in terms of nickel or moly or any of the superalloy elements going into it, those elements then are passed on through the indices to our customer. So there is some price flexibility in these contracts that already exist, even under the requirements or a firm fixed contract.

So as we see these contracts, there's no need to be suing customers. They're flexible. They were well designed. Most of them are requirements based, and we see those contracts moving straight with the industry. As the industry does better, we'll do better. If the industry does poor, we'll do poor.

Kuni Chen - Banc of America Securities

My understanding was that, as far as the airframe side of the business goes, there's more take or pay waiting there.

L. Patrick Hassey

Let's go back to that contract. That's a contract that we've invested several hundred million dollars in assets to fulfill that contract. That contract has take or pay elements to it that are guaranteed for long periods of time, and so under that particular contract, it's working as specified.

Kuni Chen - Banc of America Securities

And then just as a follow up, on the grain-oriented steel side, obviously, market conditions seem to remain pretty tight there. Can you give us some view on what level of contract increases you're seeing for next year?

L. Patrick Hassey

Well, let's just talk a little further about the market, put some color to it.

In the United States, the market certainly for residential single-phase kind of business transformers is certainly down when you see what's going in the building markets. Our contracts, again, that we have there in many cases have minimum volumes in it, so we are the supplier of choice in those contracts.

As we look at our tonnages that we have booked and moving out of the country to international customers, we have no problem filling up our entire capacity for those products this year or next year. Basically where we are today we have over 90 percent of our capacity booked and guaranteed for 2009 with improved pricing.

Kuni Chen - Banc of America Securities

Okay, but just on the pricing side, can you give us a percentage range on what you're seeing?

L. Patrick Hassey

It's double-digits up.

Operator

Your next question comes from [John Tomaso] - Private Investor.

John Tomaso - Private Investor

In framing your fourth quarter outlook, do you expect a greater deterioration in the flat rolled business from the standard stainless or do you expect it to be broadly based across most of your businesses?

L. Patrick Hassey

We expect that what we did in the third quarter in terms of volume, in terms of standards, will be very similar in the fourth quarter, but lower prices. We see the conversion prices for standard at very competitive levels.

In our other products, it mixes around, John. As we just talked about, electrical steel is very, very strong. We still have very good pull on our nickel-based alloys and titanium products that we have under contract, and we're seeing actually an improved project business load for our plate business.

So overall I would say we're looking at lower and more competitive prices on the standards and the other products that we have it depends on exactly what the mix turns out to be and what the costs of these materials are, and we'll be in the same game that we played in the third quarter as to how much compression do we get on our material side as to what the LIFO pickup will be from the final year end.

John Tomaso - Private Investor

How many dollars or shares remain on your share repurchase authorization? And as a matter of philosophy, do you want to keep buying in shares as the prices fall and improve for you to buy them back or do you want to be careful as the world behaves poorly?

L. Patrick Hassey

I'm going to let Rich answer the technical side of the question, but I'll answer your question yes and yes. We will have share repurchases in the fourth quarter, and yes, we are being very careful about our cash position. And as I said in my comments, we're currently accumulating our cash position.

Richard J. Harshman

Yes, John, through the end of the third quarter we're about 60% of the way through our $500 million authorization.

And if I could just add to Pat's comment, we've said this for a long time and we truly believe it and it's how we operate - we have a balanced deployment of our cash flow, and it's focused ultimately on how best to create long-term shareholder value. And you do that both through short-term investments in terms of being flexible and being able to sell funds or manage working capital investments, which we did through the first half of this year. We think the second half of this year, managed working capital will decrease and therefore be a source of cash.

We think the dividend policy is an important part of shareholder return. Obviously, the capital investments we're making we think make a lot of sense for long-term shareholder value creation. And then the balance sheet measures that we continue to look at to make sure that we have a strong balance sheet to navigate through the kind of economic environment that we and everybody else are in today. And then finally you have the share repurchase program. And that's how we manage the cash.

Operator

Your next question comes from Gautam Khanna - Cowen and Company.

Gautam Khanna - Cowen and Company

Could you update us on where you see '09 Capex given your new schedule on the sponge facility and the flat rolled expansion? And also just a preliminary sense of what pension expense may be [inaudible] if we were to mark it today?

L. Patrick Hassey

I'll take the capital expenditures as currently planned. Most of what we're doing next year, Gautam, is that we're finishing up the Utah plant and starting up the new premium grade sponge facility through the remainder - qualifying it, getting production out of it through 2009. We also have the major expenditures in our North Carolina superalloy facility, which is really set to crank up in the third quarter of 2009. Those are the big expenditures. Then we have some time in 2009 we have the initial placement of lead time items and the preparation of the site for the new hot mill facility.

So we still believe that our capital - and we have some expansion of our zirconium facility. Our belief is that we're still in the $500 to $600 million range. We'll manage that carefully with how the business goes, and we'll manage that carefully with the needs and the priorities, as I just outlined, of finishing up the projects that we have, making the expansions we have current business, and then implementing the longer-term plan for flat rolled.

Gautam Khanna - Cowen and Company

And on pension?

Richard J. Harshman

Yes, on the pension, it's obviously a question that anybody who has a defined benefit pension plan is grappling with. Our measurement date, as is anybody who is a calendar year fiscal year end, is 12/31. Previously our measurement date was November 30th, but with the adoption of the new financial accounting standard, we're now at 12/31.

There's tremendous volatility, as you might imagine. I don't think it would serve, quite frankly, any purpose to pretend that October 22nd was year end in terms of what pension expense may or may not be. It's completely dependent upon where the asset level is that date and what the discount rate is as of that day.

Now obviously we, like most plans, have equities in it, but we have less equities in our pension plan today than we ever have had, both from a strategic asset allocation as well as a tactical asset allocation, but we're not immune. When you look at the S&P 500, it's down 37% year-to-date. And when you look at the Lehman Brothers corporate bond aggregate, it's down 14%. So it doesn't matter whether you're in equities or fixed. If you were in fixed you were hurt less, but you were still hurt from the standpoint of what anybody's long-term return assumptions will be.

So our assets will be less than they were at November of last year, barring some miraculous recover in the equity markets that's nobody's projecting. Conversely, the discount rate is set off of the Moody's AA corporate bond yield, and most companies, like us, use a bond model that the actuaries craft that, when you select those bonds that went to the bond model, you're typically able to add a premium of anywhere from 25 to 45 basis points above the Moody's AA yield at the measurement date.

Today the Moody's AA yield - last year we used 6.25% as our discount rate. Today the Moody's AA bond yield is 7.06%. So if you were to add even the low end of that premium from the bond model, you would be over 7.25%. So that helps mitigate the lower asset level to a degree because it values your liabilities at a lower level.

We're just going to have to wait and see where all of this shakes out over the remaining two plus months, where we end up. And we certainly in the past have given guidance in our fourth quarter earnings release in January in terms of what we're looking at for the next year, that is, 2009's pension expense and we will do that at that time.

But it will affect us. I mean, this year when you look at pension - there are two components to retirement benefit expense - one is the OPEB expense, which will be roughly in the same range next year as it is this year primarily because we've capped our OPEB liabilities; the bigger impact will be the pension side. We had a pension income this year of about $12 million. I think it's very safe to say it will not be income in 2009, but it will be an expense number that is a significant change from a $12 million income level.

Gautam Khanna - Cowen and Company

May I ask also, you made a comment earlier about the superalloy nickel high performance easing a little bit on the jet engine side, and you mentioned as a response to a question that some of that was OE driven; are you seeing any weakness in aftermarket applications or perhaps any share loss as one of your customers in sources more?

L. Patrick Hassey

No, we haven't seen any loss in the aftermarket at all. What we're really talking about is on the Boeing side of the equation. As you build so many engines, eventually you can only hold so many engines before you put them on an airframe. So if the strike hit, in our view, six weeks, which is where we are now, this is the decision point for many engine builders on those particular programs.

Gautam Khanna - Cowen and Company

And with respect to share loss, are you seeing any evidence of that?

L. Patrick Hassey

No.

Gautam Khanna - Cowen and Company

And once the strike is over, how long do you think it takes before things sort of ramp back up to prestrike levels?

L. Patrick Hassey

Well, I think that's a better question for the Boeing Corporation, but I think everybody's anxious. Once this thing comes back the way it sounds is that if they can get some type of a deal, my own opinion is they could be back within two weeks.

Operator

Your next question comes from David Lipschitz - Merrill Lynch.

David Lipschitz - Merrill Lynch

Talk about electrical steel for a second. I know you talked about the markets before. How much do you see globally of increased production coming online in that market? If there's not a lot on, is there any thought of you bringing more production on or are you happy with the 120,000 tons you are now.

L. Patrick Hassey

Dave, if I had more tons, I'd love to have them today, but we've been through the periods of time when we didn't use all the tons that we have, so we had to prioritize where we're going to put capital. And certainly we could do more in a relatively short period of time if we chose to do more.

In terms of production coming online, we know that AK is adding some production here in the U.S. and there's been some other talks of newer type of ventures that would take two to three years to build. When somebody says two years, I have a hard time seeing almost anything built in a two-year period and in production. It's more like three years.

So when we look at this market, we're looking at contracts and LTAs that run more than a year. Some of them run three years, some of them run longer; some of them run a year. And we've staged these contracts so that they expire, a portion of them expire each year so that we can renegotiate. So we have a very nice position to gauging pricing, gauging competitiveness.

And also, in our particular case, we are running the lighter gauges or the harder to make products which not everybody in the world makes. And some of these new ventures that you're talking about would be in too great - that are heavier than what we think we'll ultimately wind up specializing in the high end of this market, like we have other kinds of markets. So the 120 tons looks okay. It's not that we're not evaluating what we're going to do in that market.

Under today's conditions, my own personal opinion is that the electrification of China, India, the rebuild in the United States, especially, coming in the next administration, whoever has it, is going to mean more power lines, more electrification, whether it's coming from nuclear builds in the United States and improving those assets to the electrification of China and India and other areas of the world. So I do like the business a lot.

The real issue when we look at the economic times is that these kind of projects are funded by governments or sovereign funds or, quote, the utilities of these countries. So they're not as subject to the economic woes of the world as you might think. These are the things that are going to get done.

So right now for the present, let's just say that we're going to make 120 plus tons this year. We'll make 120 plus tons next year. We do think that the hot rolling facility and the consolidation of our melt shops are the two primary targeted capital projects that we have for flat roll. We are doing incremental improvements in our electrical steel business for lower costs and for more productivity in the business.

And we'll be looking at what you asked us as to whether we do anything more with that or not in the next several months to a year.

Operator

Your next question comes from Luke Folta - Longbow Research.

Luke Folta - Longbow Research

The first question I had was regarding, you had stated earlier that you were cutting production on certain products. Is this commodity stainless steel related or should we expect to see something in titanium or some of your other metals?

L. Patrick Hassey

What we're looking at as we talk about balancing production is that, let me just put it this way, Luke, this is going to be a proactive approach to the business. If I had to put an analogy out for you based on the political times that we've heard, this is going to be a scalpel versus a hatchet.

We look at a certain business and we look at a product line like standard stainless, absolutely we are going to be balancing production to the order loads that we have. We're not going to be running heavy inventories out there just to run. We're going to balance the production as we need it, so that means the melt shop could go down for a week or two or a period of time and come back online as the orders demand it to. That means we're looking at the fixed costs we have in all of our businesses and the footprints that we have as to which products are made where and how much capacity that we need across the line.

When we're talking about high performance metals, we could be talking about balance shift operations, whether we maintain overtime and special premium shifts or whether we go to standard shifts, what kind of units that we're using for certain kinds of production of materials, whether we keep them in a more expensive path or curtail that path and put them in a lower-cost path because we have the capacity and volume to do so.

In all cases we're looking at in the end just what I said in my last statement - strong earnings and strong cash flow. That'll be the driving force in the markets that we have.

We're also looking at from a marketing side as to where we can sell these products around the world. It's not by coincidence that we had $400 million of sales, direct sales, outside the United States in the third quarter, which is normally not the strongest quarter that you'll see in the metals business.

So we are reaching to those markets where our products are needed, and we're reaching to those customers that like the particular products and the style of products and the availability of the products, the quality of the products, the applications that we're able to produce. So I think we have new opportunities short-term in China. We have new opportunities in the Middle East, in Eastern Europe, in other parts of Europe, and in the United States.

So we're looking at project work and we're balancing what we have. And we have the flexibility in this company to move operations to the point that we can balance the mix and meet the requirements at the lowest possible cost for us.

Luke Folta - Longbow Research

And just one more on sponge prices for 2009. Can you give us just kind of your ballpark quantification of what you think happens there for titanium?

L. Patrick Hassey

Well, I think, you know, the titanium price structure when we look at the scrap side of it, bulk [inaudible] processed scrap, we know that that's down in the $5 range. It had been or started this year at $12. So that has an influence that if you can buy scrap for prices less than you can buy sponge, that puts the price of sponge down to a lower level. So we're in the process of negotiating our outside sponge purchases, and we'll know what those prices are going to be.

And basically where we are is that we have facilities running in Oregon and we have a new facility starting in Utah, and we still believe that those costs will be the best costs that we're going to have in buying sponge over the longer period of time. Sponge is moving around the world from sources in Eastern Europe and Kazakhstan and Russia in ways that they are suited to make the best money that they can make, and we still have a very small percentage of sponge qualified out of China for the kind of high-end applications that we see in the markets that we've targeted.

So overall I would say that sponge prices are going to get set by the end of the fourth quarter. They'll be locked in for the year. Scrap will be a better deal than sponge.

Luke Folta - Longbow Research

Okay, but can you tell us at where you think that's going to be? Is it down 10%?

L. Patrick Hassey

I'm not going to speculate. Part of that is people's ability to buy on a competitive basis.

Operator

Your next question comes from Mark Parr - KeyBanc Capital Markets.

Mark Parr - KeyBanc Capital Markets

I had just a couple of questions, and I've been kind of in and out of the call so I may have missed some of this commentary and if I have I apologize. One thing, Pat, do you have any comments on the reset of the MSCI data? Does it look more realistic to you now or was the data better off prior to the reset?

L. Patrick Hassey

I think the service center inventories, Mark, as we mentioned, they're down to around three month. They've been about three months now the whole year, 3.2, 3.1, you know, in that range. The interesting part of that we see, the major shift in that business right now is that the U.S. service centers have been able to shift the risk of inventory for standard type products back to the mills where there are large inventories at each mill of ready coil for standard applications. This allows them to have, then, the flexibility of moving their materials sooner and to have a very secure and reliable delivery in a short timeframe. So I think that's why we see the three months.

As I said in my comments, I think you could even see that get more competitive as mills have taken the risk for the ready coil material.

Mark Parr - KeyBanc Capital Markets

I had one other question. In terms of the alloys that you're buying, in terms of the chrome, moly, nickel, etc., do you see any of these alloys having more potential for volatility than the others over the next several months or quarters?

L. Patrick Hassey

Well, Mark, right now it's a race, isn't it?

Mark Parr - KeyBanc Capital Markets

Yeah, I know. That's for sure.

L. Patrick Hassey

And nickel has certainly been the most volatile. Moly really hasn't moved very much until very recently, here within the last couple of weeks where it's moved from $33.50 a pound for moly oxide to like $27.50. It had been at $33.50 for most of the year. I think chrome is really following down, consistent with the global demand for that, which is significantly from the stainless business.

I think the other thing that we're seeing - we're not the big drivers in it, but we certainly use it in the stainless business - and that's iron scrap, which is primarily from the carbon side. That is obviously significantly off of its high.

So I think that the volatility, if I had to guess what would be most volatile, I would say it's still going to be nickel and therefore the nickel bearing scraps as well as iron scrap.

Mark Parr - KeyBanc Capital Markets

Do your contracts include iron scrap as one of the surcharge resets?

L. Patrick Hassey

Yes, all of our raw materials - and, quite frankly, all the raw materials we use - are in the surcharge index.

Operator

Your next question comes from Sal Tharani - Goldman Sachs.

Sal Tharani - Goldman Sachs

Just a quick question on pension. Were you supposed to do any funding this year or you were all set for funding?

Richard J. Harshman

No, we're not in a position where we have to fund either this year or next year, quite frankly. We have said that we've obviously made voluntary contributions in each of the last three years  four years  and our financial policy is really to look at funding voluntarily on an annual basis an amount that represents our current service costs, which is the benefit accrual that occurs on an annual basis. And that number is in the range of about $30 million.

So if there is any funding done it would be consistent with that practice of looking at minimum funding on a voluntary basis equal to our current service costs, and we would do that in the fourth quarter.

Sal Tharani - Goldman Sachs

And with the obviously asset values coming down, the market conditions, do you think there's a probability you may have to do some funding next year or you are well [inaudible] there?

Richard J. Harshman

No, I don't think we would be. We don't believe that we will be in a mandatory funding position for at least 2009 and possibly longer, hopefully longer. But I still think we would be looking at a funding policy that equals our current service costs. But it's all voluntary.

Operator

Your next question comes from Sanil Daptardar - Sentinel Asset Management.

Sanil Daptardar - Sentinel Asset Management

Pat, you mentioned about the compression on the margins because of some of the high cost material that went into the production here. When you give the guidance for the fourth quarter, is there any compression in the margins because of that or it's only because of the competitive pricing in the market?

L. Patrick Hassey

No, there is compression in the margin, again, Sanil, because when we went into this period, the price of nickel and chrome and moly and iron scrap continues to fall throughout the quarter. So far, we're watching it very carefully, but the problem that we have is that we have lead times  we have, as we said, ready coil materials in our high performance side; we have long lead times for titanium production - and so we have the scrap on the titanium side, we have the nickel-based units and the chrome and the moly and those.

So as those continue to fall or stabilize, whenever they stabilize - and that's the guess - then the compression stops. But until then, we'll feel that and we'll mitigate it by the LIFO monies coming back at the end of the quarter for the cost of the inventory going down during that period versus the average carrying price that we had of the inventories at the start of the period.

So when you put the to together I think, again, you'll see a fairly reflective margin of what the margins are. In one case it may not mitigate at all and in another case it may be better than what the compression was. But overall we think the third quarter was very representative of what the overall margins are today.

Sanil Daptardar - Sentinel Asset Management

On the standards [inaudible] product side, are you seeing any kind of recovery in the markets there or have you see the distributors' destocking coming to an end and they are still carrying low levels of inventory? Are they looking to restock or they're just staying put because of the economic pressures here?

L. Patrick Hassey

I think they're just staying put. I don't anybody is restocking or looking at this particular time to them as a bottom. No one knows. They're staying put. They're using mill inventories, and where they have contractual business, they may be carrying inventory themselves but, for the general purpose distribution applications, it's a wait and see, stay put, generate cash environment that we're facing.

Sanil Daptardar - Sentinel Asset Management

On the Aerospace side, in the case of the titanium you talked about those contracts. It was nice to hear that perspective on the TOP contracts. Of course, this might be a question for Boeing, but probably you might be able to tell us basically what kind of inventory Boeing is carrying on hand of titanium kind of products there. If there is any kind of inventory, then what might be the inventory that you might have to carry on your books and for how long you might have to carry in that case.

L. Patrick Hassey

We're not carrying any Boeing inventory on our books, and you'll have to ask Boeing Corporation what they're doing. They said in their conference call today that they were building production quantities for the ramp up of the 787.

Operator

Your next question comes from Lloyd O'Carroll - Davenport & Company, LLC.

Lloyd O'Carroll - Davenport & Company, LLC

Given your backlogs and product that's going to Boeing either directly or indirectly, if the strike were more extended - another 30, 45 days from now - would the primary hit be to Q4 volumes and earnings or extend into Q1 or Q2?

L. Patrick Hassey

Well, they won't be to Q4, Lloyd, because those things are already in place and, unless Boeing declares a force majeure to everybody, those quantities are set and moving.

And in terms of 2009, the longer that this - the longer that this strike lasts, this is production that's not made up. Boeing was running at 41 airplanes a month. That's their capacity that they want to make at this time outside of the 787. And if you don't make the airplanes, they just hang on to the end of the order book. So whatever comes into the chain that's ahead of that has to then be worked out. So that could have some periphery effects for our business.

In our own case there's minimum take or pay volumes, the titanium side, for 2009, and whether those are evenly spread across four quarters or pushed into the second, third or fourth quarter, we can't dictate that to Boeing so basically we're going to ship the minimum quantities if it gets - as you described the situation. And under those circumstances we'd probably have more effect in the first quarter than the fourth quarter.

Lloyd O'Carroll - Davenport & Company, LLC

Okay, a more positive area - let's talk about IGT. What kind of projections are you seeing for the IGT market for the next year or so, since this is one of your stronger markets right now?

L. Patrick Hassey

I would just characterize this, that the build remains strong. In our particular case, where we're producing large diameter products, starting products, for that market, we have nice positions in the 718 and 700 series products. And it appears that that's a market where the preference of the day is to continue to bridge the energy requirements through industrial gas turbines.

And so as long as that philosophy stays in place and we haven't started, you know, really building any new coal plants and we haven't really started any new nuclear plants yet, it's just in the beginning stages and the rebuild stages, so I would say that market remains strong as a bridging strategy for the next few years.

Lloyd O'Carroll - Davenport & Company, LLC

And depending on, I guess, politics, going forward the bridging could be relatively short, five years or much longer?

L. Patrick Hassey

Well, it certainly depends on the needs of the country, but I think your analysis and what you just said are the real issues - is it three years, is it five years, is it a continuing strategy along with everything else to get energy independence in the U.S. And these things are being built all over the world. Some of the markets are the Middle East and these international markets are now moving heavily into these land-based engines.

My own opinion is this is a continuing market that's not going away. It may have some fluctuations year to year, but it still looks pretty good, at least as far as our horizon looks in the next three years.

Lloyd O'Carroll - Davenport & Company, LLC

One of the trade mags cited a number of orders of IGT of up 19% for the last year. And I guess I would like to see numbers like that go on, but it's hard to tell now.

L. Patrick Hassey

Yes. Well, the last time we had the cycle it lasted about three years, right?

Lloyd O'Carroll - Davenport & Company, LLC

Yes. Yes, thanks to Enron.

L. Patrick Hassey

Well, thanks very, very much everyone for joining us today. We appreciate your continuing interest in ATI and for attending our earnings conference call today.

Dan L. Greenfield

Thank you, Pat, and thanks to all the listeners for joining us this afternoon. As always, news releases may be obtained by e-mail and are available on our website. Also, a rebroadcast of this conference call is available on our website. That concludes our conference call.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a wonderful day.

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Source: Allegheny Technologies Incorporated Q3 2008 Earnings Call Transcript
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