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Carpenter Technology Corporation (NYSE:CRS)

F1Q09 Earnings Call

October 28, 2008 10:00 am ET

Executive

Anne L. Stevens – Chairman, President, Chief Executive Officer

K. Douglas Ralph – Senior Vice President – Finance, Chief Financial Officer

Michael L. Shor – Senior Vice President – Premium Alloys Operations

David Christiansen – Vice President – Investor Relations and Business Development

Kathy Handley – Senior Vice President – Organizational Effectiveness

Analysts

Luke Folta – Longbow Research

John Sullivan – Leerink Swann, LLC

Dan Waylin – [Unknown]

Timothy Hayes – Davenport & Company

Leo Larkin – Standard & Poor’s

Robert P. Fetch – Lord Abbott

Gautam Khanna – Cowen & Co.

Lloyd O’Carroll – Davenport & Company

Mark Parr – KeyBanc Capital Markets

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2009 Carpenter Technology earnings conference call. My name is Jasmine and I’ll be the operator for today. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of the conference. (Operator Instructions).

I would now like to turn the presentation over to your host for today’s call, Mr. Dave Christiansen, Vice President of Investor Relations – Business Development. You may proceed, Sir.

David Christiansen

Good morning. Thank you, Jasmine. Welcome to Carpenter’s earning conference call for the first quarter ended September 30, 2008. This call is being broadcast over the Internet.

With me today are Anne Stevens, Chairman, President and Chief Executive Officer, Doug Ralph, Senior Vice President and Chief Financial Officer, and Mike Shor, Executive Vice President of our Premium Alloys and Advanced Metals Operations, as well as other members of the management team.

Statements made by management during this conference are forward-looking statements based on current expectations. Risk factors that could cause actual results to differ materially from these forward-looking statements can be found in Carpenter’s most recent SEC filings, including the company’s June 30, 2008, 10K and the exhibits attached to those filings.

I will now turn the call over to Anne.

Anne L. Stevens

Thank you, Dave. Good morning, everyone. As you can see from the earnings release that we issued this morning, we did not achieve the results that we had anticipated in our first quarter. There are several reasons for the difference in our earnings from last year. Our markets are showing some weakness. Our operating costs were higher. And raw material prices had a negative effect on our business during the quarter. Doug will provide more colour on these issues in a moment.

I would like to focus on the conditions of our markets and on the actions we are taking in response. Growth slowed in our key aerospace and oil and gas markets this quarter as near-term market conditions affected demand. Late in the first quarter several of our customers in these markets began to delay and reduce orders. Their actions reflect the impact of the Boeing strike, as well as the cumulative effect of both the 787 and A380 delay and the grounding of part of the domestic fleet. There was also a build-up of inventory in the oil and gas supply chain. In addition, Carpenter’s business is being affected by the global economic slowdown.

It is clear from general economic data and leading indicators, and from conversations with our customers, that the potential impact on our markets could be significant if current trends continue. Let me tell you what we’re doing about this.

First, we have streamlined the organization structure to improve the efficiency and reduce costs. As part of this restructuring we have reduced our upper management positions by 20%. Mike Shor has been appointed executive vice president with the responsibility to lead the operating units.

Second, we have identified and taken steps to capture additional cost reduction in all areas of our business. We are increasing the frequency and depth of our cost performance reviews and profitability analysis on all items.

Third, despite the near-term problems we face we’re still optimistic about our long-term growth plan. Our ongoing strategic investments in technology, R&D, marketing, and international growth will help ensure the future long-term success of Carpenter’s business. These have been and will continue to be areas of intense focus and attention for all of us.

Now let me review the end markets for the first quarter. To provide better insight into our performance the year-over-year revenue comparisons exclude surcharge. Aerospace sales were $115 million, essentially flat from the first quarter a year earlier. The results reflect the impact of the various issues affecting the aerospace industry compounded by the machinists strike against Boeing which combined to cause a slowdown in demand for specialty alloys, especially for engine applications. Compared to last year’s first quarter sales of specialty alloys used in jet engines were lower in the US, but higher in Europe.

Energy market sales were $44 million, an increase of 19% from last year. The demand for materials used in industrial gas turbines continued its strong performance reflecting the need for additional power generation facilities in the US and Middle East. The oil and gas sector growth rate has slowed due to full inventories in the supply chain.

Medical market sales were $22 million, a decrease of 15% from the first quarter a year ago, although shipments increased 1%. The reduced medical sales primarily reflect substantially lower titanium raw material prices compared to last year and a weaker product mix.

Industrial market sales were $70 million, an increase of 2% compared with last year. The results reflect growth in general industrial applications offset by slowing demand for materials used in semiconductors and in valves and fittings.

Automotive market sales were $26 million, down 32% from the first fiscal quarter of 2008. The decline reflects significantly lower sales volumes in the domestic market and somewhat lower volumes in Europe and Asia Pacific.

Consumer market sales were $24 million, a decline of 6% from the quarter a year ago. The drop in consumer sales reflects the decline in the US housing market and lower demand for supports, electronics, and other consumer applications.

Including surcharge, Carpenter’s first quarter international sales were $153 million, an increase of 3% over last year. Overall international sales represented 37% of total sales during the quarter.

Now let me turn the call over to Doug.

K. Douglas Ralph

Thanks, Anne. I will start by providing perspective on our first quarter results and then I want to make a few comments about our overall financial position given everything that is going on with the financial and credit markets.

Net sales in the quarter were $414 million or 8% below a year ago. Backing out the surcharge sales were down 3%. Overall tonnage volume decreased 1%. In terms of product forms, special alloys grew 2%, titanium products grew 15%, and stainless steel products were down 3%.

Our profit performance was short of our expectations and we are taking actions to address this, as Anne outlined. First quarter gross profit was $74 million compared with $115 million a year ago. Excluding surcharge revenue our gross margin in the period was 24.4% versus 37.1% in last year’s first quarter. About a third of this profit difference is due to a weaker product mix, lower volume, and some negative pricing impacts.

On product mix, which was the biggest of these factors, we shipped more low-end than high-end stainless products and the mix of our aerospace and energy products was weaker than last year’s first quarter. Our pricing levels have generally held up pretty well.

Another third of the difference is from higher operating costs. We incurred costs in other production inefficiencies due to the significant amount of the equipment upgrade and maintenance activity that we undertook in the first quarter, particularly on our major rolling mill. Beyond this we experienced increased costs in a variety of areas, including general inflation, energy and freight, depreciation in supplies, which were only partially recovered through our surcharges and other pricing.

The final third of the quarter-to-quarter profit difference ultimately traces to the difference in nickel prices this year versus last, both the absolute level and the relative slope. Last year the average nickel price in the first quarter was about $15.50 a pound, moving down from about $22.50 a pound in the prior quarter or a difference of $7 a pound. In this year’s first quarter the average nickel price has been about $9.25 a pound moving down from about $13 a pound in the prior quarter or a difference of $3.75 a pound, which is about half the drop experienced last year. This reduces the positive surcharge lag effect we realized when nickel prices declined. And the lower absolute nickel price also ripples through other parts of the business, like the value we receive for outside scrap sales.

In addition, we experienced the negative timing effect as a result of customers pushing out some volumes that we had hedged for under long-term agreements. This will be recovered in future periods when they take the volume.

One partial offset to all this is the LIFO impact on our inventory build, which is more positive in this year’s first quarter versus last year. However, as with last year, this will come back as a negative in the latter part of the year when inventory levels are reduced.

So in net there are a variety of items that negatively impacted our profitability in the first quarter, some of which will naturally improve over the balance of the year and other areas that we need to address through the costs and other business improvement actions that we have put in place.

Returning to the income statement, operating income was $40 million compared with $82 million in last year’s first quarter. We have held a tight lid on our selling, general, and administrative expenses which increased only 1% year over year and would have declined by 3% without the increase in non-cash pension expense that we’ve highlighted previously and noted in our press release.

Other income in the quarter was $4 million compared to $6 million in last year’s first quarter. This primarily reflects lower interest income as a result of overall market interest rates and our shift to a more conservative investment portfolio.

Our first quarter income tax provision was $14 million or 35% versus $28 million or 33.2% in the same period last year. The full-year effective tax rate is expected to be about 34% and includes the recent extension of the R&D tax credit which will begin showing up in our second quarter tax rate.

Overall, first quarter net income was $26 million or $0.58 per diluted share. The year-ago first quarter had comparable income from continuing operations of $55 million or $1.07 per diluted share.

We ended the quarter with free cash flow of $13 million. Within this, our capital spending for the quarter was $36 million. We also experienced an increase in inventory levels which was negative to cash. We are taking actions to manage this down over the balance of the year.

Overall, we remain in very good financial shape. We finished the quarter with $385 million in cash and marketable securities and have another almost $200 million in available credit commitments if we were to ever need that, so liquidity is not an issue. We’ve taken that cash and invested it in very conservative treasuries and agency backed securities, which is appropriate given the current economic climate.

The $300 million of debt on our balance sheet does not mature in any significant amount until the summer of 2011, with the balance in 2013 and after. We are also closely monitoring the quality and collection of our accounts receivable and have seen no issues at all there.

We expect to be a positive cash generator this year despite a significant level of capital investment. With the changes that have been made to our costs and debt structure since the beginning of this decade and the additional actions we have recently taken we would expect to generate positive cash flow in most realistic downturn scenarios if that were to occur. So with all this we’re in very solid shape and can potentially use this strength as a tool for growth if the right opportunity presents itself.

The last thing I’ll comment on is our share repurchases. For the quarter we bought back 1.2 million shares at a cost of $46 million. This completes the second $250 million authorization we had for share repurchases. We have no further board authorization in place at the current time and will evaluate this as we get better clarity on market conditions and other alternatives for cash deployment going forward.

With that let me now turn things back to Anne.

Anne L. Stevens

Thank you, Doug. Even with the growing concerns in the global economy, Carpenter is well positioned to manage the challenges ahead of us. After the last downturn following 9/11 Carpenter took quick actions to sharply lower our costs. Since then we’ve reduced our debt and accumulated healthy cash reserves. Our base business is strong and should continue to generate good cash flow.

These resources give us the ability to handle the current economic conditions without departing from our longer term growth initiatives. However, in light of the increasing potential for a broader economic downturn we believed it was appropriate to take additional action, so we restructured our management and are further cutting other costs to prepare for the unpredictability of the current market conditions.

In the long term, though, the outlook for our key markets of aerospace and energy are quite strong, both domestically and internationally. We’re using our resources not only to manage through the current economic situation but also to continue to invest for growth.

Despite the strength of our long-term prospects, our outlook for the rest of the year is unclear. The economic slowdown will likely inhibit our near-term growth and to lay our ability to achieve the revenue, margin, and earnings objectives that we set for the year.

Although we have taken actions to streamline our operations and reduce costs, it is too early to predict the degree to which our results will be affected by the economic situation in front of us. With the talent and experience of our employees and our management team’s expertise I am confident that we will profitably manage our business through the current condition. I am equally confident that we will also maintain a base from which we can accelerate our growth when the markets recover.

With that we’ll now open our line for questions. Thank you, Jasmine.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Luke Folta – Longbow Research

Luke Folta – Longbow Research

Hi, good morning. First question I had, would you be able to break out for us sales by product including the surcharge?

Anne L. Stevens

Yeah.

K. Douglas Ralph

Sales by product including the surcharge.

Anne L. Stevens

Hold on. Just give us a couple seconds. We will locate the data.

Luke Folta – Longbow Research

I guess I’ll ask my second question. Regarding what you’re seeing as in the Airbus supply chain, has there been any real change in your expectations there due to the economic situation?

Anne L. Stevens

Not at this point in time. The majority of what we have seen was due to the impact of the Boeing strike that was out there as well as just some general concern in the economy. Honestly, we really don’t separate out whether the material is destined to Airbus or to Boeing. Overall I would say no.

Luke Folta – Longbow Research

Okay. And you talked a lot about some cost initiatives that are underway. Can you give us some sort of quantification on how much you think might be available to take out of the system?

Anne L. Stevens

Yeah, let me just tell you the way that I look at it. I constantly monitor the fixed-cost structure of our business because that’s really important in generating positive cash flow. Now, as we started to see the top line come down then I realized what I needed to do was adjust the fixed-cost expenditure of the company. So at this particular point in time I can’t give you a dollar number, but I will tell you that we are reducing our fixed costs by two percentage points. I will constantly monitor that top line and keep the costs under control.

Luke Folta – Longbow Research

Okay.

Anne L. Stevens

Do you have the data, Doug?

K. Douglas Ralph

Yeah. Luke, I’ve got this sliced about any way that you want it. You’re looking for product form or end market?

Luke Folta – Longbow Research

I was looking for product form with surcharge.

K. Douglas Ralph

Product form with the surcharge. So stainless steel products, $144.9 million; special alloys, $205.2 million; titanium products, $41.8 million; and then we have other products that add up to the balance of the $21.8 million.

Luke Folta – Longbow Research

Okay. All right. I’ll turn it over. Thanks a lot guys.

Anne L. Stevens

Thank you.

Operator

Your next question comes from Gautam Khanna – Cowen & Co.

Gautam Khanna – Cowen & Co.

Hi. Well, first, at a high level, given the earnings came in considerably below consensus, I just wonder what is your philosophy with respect to pre-announcing. A couple quarters ago you pre-announced when you knew the numbers would be a lot lower than what consensus was looking for. You didn’t do so this quarter. Is this because you didn’t have the visibility until late in the quarter? Did things get serially worse through the quarter?

K. Douglas Ralph

Yeah, I think, Gautam, the last time that we pre-announced we were adjusting statements that we ourselves had made, not really commenting on how we expected it to come out versus the consensus estimate. Since we didn’t have any similar statements out there regarding our first quarter results, and also because things, I think, for us and the rest of our industry have been pretty dynamic recently, we didn’t feel a pre-announcement was warranted in this case.

Gautam Khanna – Cowen & Co.

But you did pull your guidance today, right? Just so I'm clear. You’re not –

K. Douglas Ralph

In the fiscal year, right. We did not make any quarterly estimates. But previously in the fiscal year we had talked about expectations for a record EPS year, and it also made comments about our overall operating margin ex surcharge for the fiscal year being in line with last fiscal year. We no longer expect either of those to be the case.

Gautam Khanna – Cowen & Co.

Okay. You mentioned on the aerospace side seeing some slow down. Can you characterize what percentage of your nickel-super alloy business that goes to aerospace is intended for aftermarket versus OE and where you saw the softening, whether it was OE or aftermarket?

Anne L. Stevens

Yeah, you know, again, when we supply the material that goes to the forgers destined for the engine parts we have no idea whether that’s going to replacement engine parts or whether that’s going for the build of new planes. But we have taken some time to estimate this and as best as we can estimate it with the data that we have it’s roughly 25% plus or minus that goes to replacement parts and the balance goes to new airplane construction.

Gautam Khanna – Cowen & Co.

Okay. And since the Boeing strike appears to have ended, do you expect kind of a return to normal levels? More tracking the actual unit deliveries any time soon or do you think there’s an inventory overhang that’s going to take some months to work through?

Anne L. Stevens

Yeah, you know, as you’ve received the tentative agreement between Boeing and the machinists union was just announced today, if the union ratifies that agreement it’s going to be good news. But there are so many other factors out there in the overall economic outlook. It’s a little too soon to tell on that one.

Gautam Khanna – Cowen & Co.

You mentioned on oil and gas that the inventories, there may be a bit of a glut. Is this an inventory issue or is it also an issue of oil prices have dropped a bit and perhaps some of the marginal projects are being scrapped all together. Are you seeing any pushback on that front?

Anne L. Stevens

Yeah, you know, what I’m going to do is I’m going to let Mike Shor answer that question because he’s been spending quite a bit of time with our customers on that one.

Michael L. Shor

Good morning. The majority of the issue that we’re seeing right now in oil and gas is because our customers are seeing significant inventory that’s been built up in their supply chain. I think with the drop in energy prices I think we may see a little more, actually, but right now it’s really related to the inventory that has been built up in the supply chain.

Gautam Khanna – Cowen & Co.

How many months of inventory do you think they have to destock?

Michael L. Shor

Tough question to answer. I would say with all the different products involved the range is significant. There are some products that we still have significant demand on, but there are other products that have extensive amounts of inventories out there.

Gautam Khanna – Cowen & Co.

Okay. And lastly, titanium wire for aerospace fasteners; are you seeing a glut in that inventory supply chain? Of inventory in that supply chain?

Anne L. Stevens

No. You know, actually that one, the demand has been pretty flat. I know that with some of the changes that were made on 787 the fastener suppliers were in a catch-up mode. So the demand on that has been relatively flat.

Gautam Khanna – Cowen & Co.

Okay. Thank you.

Operator

Your next question comes from John Sullivan – Leerink Swann, LLC.

John Sullivan – Leerink Swann, LLC

Thank you. I just had two quick questions. One was with regard to volumes. I was wondering about the relative impact of end markets and the work on the rolling mill. If there hadn’t been the difficulties with the rolling mill would volumes have been higher than they were?

And the second question was, in your prior guidance you had mentioned a ramp up in results in the second half of fiscal 2009. Is that something that you continue to expect or is that now unclear given the general outlook?

Anne L. Stevens

Let me address the performance of the mill and volumes and then I’ll turn over to Doug to basically talk about what, if any, guidance you want to give on that for the second quarter.

With respect to the five mill and looking at the inventory that we have; as you know, melting the product is way ahead of the products that need to be rolled. What had happened with the five mill, and that’s the code name internally to that mill, that’s a 16-station rolling mill and that mill, even though it started up, it had its ups and down due to the significant rolling change. So one thing that was impacted in that was just the overall inventory because the throughput of the five mill was less than expected. So in overall for the first quarter we had said that the performance was going to be down year over year and we knew some of it was going to be constrained in that five mill. It had to effects. One on the volume side, as you pointed out, we would have had more throughput through there and had higher volumes. The second impact that it had on us were costs and inefficiencies. Because when you have the labour in here, plus the other thing that we did experience through the start-up of that rolling mill is incremental scrap production and something that we call cabo (sic). That’s when the mill goes down and the material gets stuck in the process. So it had the two impacts on that. Would throughput have been greater had that equipment launched as expected? The answer is yes.

In terms of forward looking into the second quarter, I’ll let Doug answer that question.

K. Douglas Ralph

Yeah, John, and just on the volumes, I don’t know whether you wanted the specific numbers. They’re mostly in our press release, but I’ll just rattle down through those for the quarter. Overall our volume was down 2% and the only end market that was down was automotive, which was off 29% in volume terms. Aerospace was up 3%. Energy was up 21%. Our industrial business was up 1%. Medical business up 1%. Our consumer business was up 1%. So for you or anybody else that wanted the numbers there.

In terms of second half versus first half guidance, we’re not going to make any specific comment on that, but I will give you a little bit of flavour. The biggest wildcard, of course, is the economy and end market conditions. Right now these are just too typical to predict. Some positive things that will be occurring during the course of the year is that there were certainly some non-recurring impacts that we had in the first quarter, the significant amount of equipment start-up activity, as well as the timing effect from our raw material hedging are two of those. We also would expect that the costs and other improvement actions that we’re taking should be positive to results over the balance of the year. Our mix should also improve with the start-up of our new premium melt capacity.

A big one countering that would be we would expect to have a negative LIFO impact as we reduce inventories over the balance of the year. So those are some of the puts and calls, but overall it’s just too difficult to predict with the overall economy and end market conditions right now.

John Sullivan – Leerink Swann, LLC

Okay. Great. Thanks a lot.

Operator

Your next question comes from Dan Waylin – [Unknown].

Dan Waylin – [Unknown]

Thank you. If things continue to get considerably worse, and looking at some of your shorter retime end markets, how nimble can you be with your production levels and what kind of costs would be associated, order of magnitude, with curtailing some of those production levels on the auto, the consumer type end markets there.

Anne L. Stevens

Michael will address that one because obviously that’s some saying that we’re looking at.

Michael L. Shor

Dan, one thing that we have great opportunity to do when our markets are shifting is air products typically go through the same equipment. So we have the opportunity, for example, if automotive goes down to backfill with other products that may be coming through. We also have the opportunity, should we need to, to move people from one area to another. So we have the ability because of the equipment we have to be able to shift from market to market based on the business conditions.

Dan Waylin – [Unknown]

Okay. Great. Thanks. I had one other question. You may have addressed this earlier. I had to step off for a second. Just in terms of your difficulties in upgrading the rolling mill. Can you just, order of magnitude, what kind of costs were associated with that during the quarter that may go away next quarter?

K. Douglas Ralph

Yeah. Nothing specific I can give you there. It’s a difficult area internally because there are a lot of what we would describe as indirect impacts from that. So we can look at direct costs, but then downstream of the rolling mill, you know, in our finishing operations and other things, as well as just general opportunity costs that would have had on our volume there are other indirect. So it certainly had a significant enough effect that we called it out in our quarterly results, but anything more specific than that we can’t provide.

Dan Waylin – [Unknown]

Okay. Thank you.

Operator

Your next question comes from Lloyd O’Carroll – Davenport & Company

Lloyd O’Carroll – Davenport & Company

Yes. What’s the status on the melt capacity expansion and when will that be in full operation?

Anne L. Stevens

Thank you, Lloyd. The project is going really well. That’s something that obviously we review constantly. So what I can tell you is it remains on schedule. As we have previously said, it will be completed by the end of this calendar year. All four of the VARs are currently operating. The first ESR furnace began operation in September. The 20-tonne VIM furnace is scheduled to start melting in December. We’re very pleased with the progress that the team has made to date.

Lloyd O’Carroll – Davenport & Company

Okay. So this would give you some additional capacity for the second half of the fiscal year. Assuming that demand is actually there, then that would be a positive.

Anne L. Stevens

Yes. We would have some additional capacity on line for the second half of the fiscal year. Pending the demand is there.

Lloyd O’Carroll – Davenport & Company

To what extent has capacity been an issue in either Q1 or thus far in Q2, or is it more of a demand this year?

Anne L. Stevens

Well, when we went into the quarter demand exceeded supply. As we got into the quarter we still had capacity constraints. Obviously if you look at the lead time on melting, we melted a lot of material, which is some of the explanation for the inventory that we had this particular quarter. Also, there was some demand slowdown. In terms of five mill there was a throughput issue that particularly impacts the AMO part of the business.

Lloyd O’Carroll – Davenport & Company

Okay. Thank you.

Operator

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

Mark Parr – KeyBanc Capital Markets

Thanks. Good morning. I wanted to follow up a little bit on the five mill issue and also just what you’ve seen occur with your backlog. You’ve talked in general terms about the market dynamic. Can you quantify at all in terms of what you’ve seen on the backlog front?

Anne L. Stevens

Yeah. What I can say on the backlog front, it’s not necessarily an indicator of what performance is going to be, but the backlog remains healthy and, in fact, it has increased over the last year. Again, I’m not going to say that the backlog will predict what the performance is.

On the rolling mill, Mark, can you be more specific with what your question is?

Mark Parr – KeyBanc Capital Markets

Yeah. I was just curious with the throughput issues that you had subsequent to the upgrade, what sort of influence to backlogs has that had?

Anne L. Stevens

Really nothing.

Mark Parr – KeyBanc Capital Markets

All right. So you mean to say, the through put issues essentially were resolved over the course of the quarter, but you just had some inefficient operations that hit the results. Is that fair?

Anne L. Stevens

Yeah, that’s a fair statement. I would say that the resolution of the issues occurred later in the quarter than what we had originally planned. Some of this, and I’ll just make one comment so I don’t teach you how to build a watch when you ask me what time it is, basically what we had done last year, you may recall, we experienced some inefficiencies because what we were doing was taking that rolling mill down every single weekend and doing some pre-work on the control systems. So with that what we had expected is a quicker ramp up to old production levels as we went into this year. That didn’t happen. Now, had we not done that we may have had more software issue than we experienced, but we experienced a lot more software issues? Because it’s very complex. You’ve been out there. It’s a 16-station rolling mill. So the issues have been resolved, but really occurred much later in the quarter. We still have some unfinished business that we’re working on that we have to attend to to get to the target performance levels. I can tell you we’ve had one week of good performance, but again I can’t sit here and say that we’re 100% through all of it. I’m encouraged, but it’s still slower than I expected.

Mark Parr – KeyBanc Capital Markets

Okay. Thanks for that. If I could ask another question on the aerospace side. The Boeing situation looks like it’s getting resolved, but there’s been an issue of parking of planes and reductions of flight schedules for the domestic carriers. I’m wondering if any of your market intelligence would suggest that you’re seeing similar types of changes in flight schedules outside the US or if you expect any of that to unfold over the next quarter or two.

Anne L. Stevens

I’m sure you, as well as we have done on this side of it, have really pushed every source we can to just get the view out there. Because as you know, the July forecast from Airline Monitor had estimated that Boeing and Airbus together were going to ship 1050 aircraft in calendar year 2009. From what we hear and what we believe we think, and there are indications out there, that that number is high. That both the global economic troubles that you point out, it’s not just US, it’s some global issues as well, and the Boeing strike, which obviously has impacted the number of planes that can be built this year, is going to have impact and believe that it is going to work its way through the supply chain. I think there is an impact. There will be less planes built. Obviously in 1050 how much more is there from global economic demand issues versus the supply chain adjustments that we have to make from the strike is still to be determined. Every indication that I have is I still believe, as we look at the long term, this is a good market. I’m confident in the market even with some of the stops and starts that have happened to us this year.

Mark Parr – KeyBanc Capital Markets

It’s interesting that your aerospace volume was actually up year on year in the face of all this weakness. I was wondering if you could provide a little colour on that?

Anne L. Stevens

Yeah. I’m going to let Mike talk about that. One thing that I would say, as you know, we have really focused the effort both on aerospace and energy and have had some good success with the long-term contracts that we have negotiated with our customers. Mike again has been visiting quite a few of these customers the past couple weeks and I’ll let him provide some additional comments.

Michael L. Shor

Couple things. I would say that we continue to expect to grow at or above the growth rates for this market. We’re committed to doing what we need to do from quality cost delivery standpoint to be the supplier of choice in these markets. We continue to work very hard to expand our relationships with them. Obviously our share that we’re looking at is not just domestic, but it’s global. So working very hard with our customers to grow our business and even faced with what we’re dealing with now with the economy.

Mark Parr – KeyBanc Capital Markets

Okay. Would you expect the aerospace market would have the potential to be down 10% in 2009 relative to 2008 based on these issues that we’ve been talking about? I’m just talking about the industry overall.

Anne L. Stevens

I don’t think it’s going to be down that much, but that is just my opinion based on the conversations that I’ve had and the data that I’ve been able to pull along with my marketing team.

Mark Parr – KeyBanc Capital Markets

All right. Terrific. Well, hey, thank you very much for all the colour and good luck here in this touch environment that we’re moving into.

Operator

You have a follow up question from Gautam Khanna.

Gautam Khanna – Cowen & Co.

Hi. The upper management changes that you’ve made, could you elaborate specifically what you are doing and what could be severance charges in the next quarter?

Anne L. Stevens

I will give you the strategy and I will let Doug give you the estimate of any charges. When I basically looked at the economic conditions that we’re all facing, regardless of what business we’re in, I firmly believe that you’ve got to take action. You have to take decisive action and take the actions quickly. We had staffed the senior team for much more top-line growth than what we have recently experienced. So along with that I spent quite a bit of time with the executive team and basically took a look at what was working, what was not working as well as it could work, and how could we eliminate any confusion, provide straight clarity to the teams, and give crystal clear accountability. So the actions that I took were focused 100% totally at the senior vice president, the vice president, and the director levels. I had a target of not only a cost reduction, but a reduction and structure along with improved performance and accountability. That was the strategy and it has been done. This is not something that I’m talking about a plan. This was something that we executed last week.

Doug, do you want to address the comment on costs?

K. Douglas Ralph

Yeah. There were some severance and other costs needed to achieve those savings. They’re not anything that we would view as significant enough to highlight in this call. Of course, we’re a third of the way into the year and we’re going to stay away from quoting specific numbers. But I would say that you could expect to see favourable trends in our reported SG&A numbers reflecting these actions over the balance of the year going forward.

Gautam Khanna – Cowen & Co.

Since you called it out on the top of the press release I imagine it’s more than, it’s not insignificant. Could you talk about the number of people that were reduced? What the annual salary savings will be? I mean, you called it out, so I’m just asking a follow up here.

K. Douglas Ralph

It’s a 20% reduction in our upper management positions from director and up. There will be positive benefit on the bottom line net of any savings or costs to achieve those savings. As I mentioned, I think you will see in our reported SG&A results when you take the special Boarhead Farms litigation reserve out of last year’s number, favourable trend in our reported SG&A numbers going forward.

Gautam Khanna – Cowen & Co.

Can you tell us how many folks there are in upper management? The 20% relates to what?

K. Douglas Ralph

Rough numbers....

Anne L. Stevens

I have Kathy Handley [sic] here. Kathy is our senior vice president of organizational effectiveness. Kathy, do you want to respond to the number? I don’t want to quote a wrong number, so Kathy can give you a more accurate number.

Kathy Handley

In our total upper management structure we have approximately 56 folks in what we call the upper management level, which would be director level and above.

Gautam Khanna – Cowen & Co.

Okay. So you have 56 today, as of last week you had 65 or something.

Kathy Handley

Approximately, yes.

Gautam Khanna – Cowen & Co.

Okay. Great. And could you just walk us through the LIFO impact we should expect for the rest of the year? Build inventory in the first half; you work it off in the second half. Obviously the cost of the inventory is dropping. How should we think about the impact on margins going forward?

K. Douglas Ralph

The positive number in our first quarter is about $9 million. That again compares to a positive number in last year’s first quarter. So if inventories were to return to the level the level that they ended up last fiscal year that $9 million would hit us negatively over the balance of the year as the inventory comes off.

Gautam Khanna – Cowen & Co.

Okay. And you’d also mentioned the hedging activities from your customers delaying accepting deliveries. What kind of protection do you have on these long-term agreements? Is there an opportunity for them to delay indefinitely? Is it a requirement space thing? How much flexibility is there in the schedule?

Anne L. Stevens

This is obviously something that we work with customers on. All the contracts are negotiated a bit differently. At the end of the day we are as flexible as we can be. All the contracts are different, but we do expect that the customers are going to keep their commitments to us.

Gautam Khanna – Cowen & Co.

Their commitments are contractual or are they just kind of requirements based? Whatever their needs are they buy from you.

Anne L. Stevens

Well, the contracts are different. So we don’t have one contract for all customers. It obviously depends on the buying pattern of the customers as well as on the terms and agreements of the particular contract. Again, we do look at market conditions and will give as much flexibility in terms of the quantities and buying patterns that we can. At the end of the day we do expect the customers to live up to their commitments.

Gautam Khanna – Cowen & Co.

Can I ask, though, I mean, you specifically called out a third, a third, a third. One of the thirds of the operating profits shortfall was some of the product mix and some of the stretch out. The question is, of those that have stretched out are these requirements based contracts over do you have firm commitments that they have to take delivery by some date and time?

K. Douglas Ralph

Yeah, our expectation, Gautam, is that the customers are going to take the volume. These are all under long-term agreements. The customers are fully aware and in fact initiate when we go out and hedge at a certain nickel price level. Given everything that’s been going on in the markets and given that these are important long-term customers to us we just have to be flexible and acknowledge their marketplace reality. So that has caused some push outs versus the timing that we initially hedged against which has caused a negative impact in our first quarter and it’s our expectation that as the customers take these volumes under their long-term agreements that would offset that negative in the first quarter.

Gautam Khanna – Cowen & Co.

And the negative was where? Walk me through the negative on the P&L. I understand you’ve got the inventory, you’re stuck with that, but walk me through the P&L impact and when you actually deliver that what’s the pop we’re going to get to reverse it?

K. Douglas Ralph

Basically, the negative that we have is that as that hedge contract expires at a lower nickel market price then what the hedge contract is at creates a negative from that hedge contract that ultimately is offset by the positive that we would see in our revenue from the customer taking that volume at the hedged upon price.

Gautam Khanna – Cowen & Co.

And they’re committed. You’re saying that you expect them contractually to be committed to honour the hedge price, even though it may have been 2x the current market price.

K. Douglas Ralph

Yeah, we absolutely expect that.

Gautam Khanna – Cowen & Co.

Okay. Are these customers, do you have any sort of, I mean, given the credit mess, are you seeing any weakness in the financial stability of some of your customers? Are you seeing an inability to get financing or what have you that could actually make it a little bit more of a risk going forward?

Anne L. Stevens

Not that we have seen up until this point. This is really something that we look at. One thing that we carefully monitor are the days outstanding in terms of payment. We’re not seeing anything negative there, nor with what the team has seen do we expect anything negative. I can’t predict what the future is going to bring, but up until this point in time we don’t see any negative impact on us.

The other comment that I will make to you on your previous line of questioning, commitments that we have with our customers are annual and not quarterly. When we talk about being flexible to work with them pending market conditions we do so. However, at the end of the day we do expect commitments to be met. I hope that clarifies that.

Gautam Khanna – Cowen & Co.

Yeah. That’s very helpful. I just wanted to ask one last one. I remember a couple quarters ago you had some option rate securities. You mentioned you now have much more safe investments. Could you walk through where your cash is today?

K. Douglas Ralph

The bulk of our cash is treasuries and agency backed securities. We’re not making a wonderful return on that these days, but safety is the priority. We do still have, as of the end of September, some option rate securities right at about $11 million. That is slowly but surely clearing off our books. Into the end of September we probably had another $4 million to $5 million of that $11 million clear, but it’s something that we monitor closely. We’ve made a number of changes over the course of our first quarter to move into safer investment vehicles.

Gautam Khanna – Cowen & Co.

Okay. And last question. I’m sorry to ask all these questions. As you bring on the premium melt furnaces can you walk through how your D&A is going to change? I mean, are we going to see an uptick in Q3 or how does that play out?

K. Douglas Ralph

We’d expect this year’s D&A to be just a shade under $55 million, which is up by a little less than $5 million versus what it was last year. The biggest driver of that is the premium melt expansion project.

Gautam Khanna – Cowen & Co.

Okay. Thanks a lot guys.

Operator

Your next question comes from Tim Hayes – Davenport & Company.

Timothy Hayes – Davenport & Company

Good morning. Just a question on business trends during the September quarter. How did the quarter progress month to month? It seems takeaway, or at least my take away from the call so far is that September did have a meaningful drop off in both shipments and from the other two months? Just if you could talk about how those trends went during the quarter.

K. Douglas Ralph

Well, September was certainly the month where the Boeing strike would have impacted us. I think before that just some of the general economic factors and certainly a market like automotive was negatively impacted during the entire quarter. But I would say in aerospace and specifically the Boeing strike impact was more back loaded in the quarter.

Timothy Hayes – Davenport & Company

Any difference on October versus September?

K. Douglas Ralph

I’m sorry, I missed the question.

Anne L. Stevens

October.

K. Douglas Ralph

The Boeing strike has continued on through October.

Timothy Hayes – Davenport & Company

Aside from just the Boeing impact. Other parts o the business October versus September.

Anne L. Stevens

Well, we had already talked about the supply chain in energy and so we’ve seen some slow up in that. That continues. In terms of, just, you know, if you want to just look at the distributor side of the business that we’ve talked about before, that’s more price sensitive side so you do see pressure and some hesitation there. With nickel prices in the $4 plus range you’re basically seeing that end of the business people not only being cautious to spend as minimal as they can on the surcharge but they’re also very, very conscious about conserving their own cash. So we are experiencing some softness in those markets as well.

Timothy Hayes – Davenport & Company

Right. And then in terms of seasonality, how do you think of the September quarter then going into the December quarter? Is the December quarter typically a bit weaker seasonally from September?

K. Douglas Ralph

Yeah, our first two quarters because of various customer shut down effects, either summer shut down or holiday shut down, they tend to run about 45% of the year versus 55% in the back half of the year. That’s our normal seasonality.

Timothy Hayes – Davenport & Company

Right. I understand the sort of first half versus second half. I just wanted to get more of a feel of the September quarter heading into the December quarter. Is it fair to say that both quarters are approximately equal to each other?

K. Douglas Ralph

Yeah. I mean, absent any other market conditions I think just if you were to look over time in the company there wouldn’t be a significant difference between first and second quarter because of the either summer versus holiday shutdown period.

Timothy Hayes – Davenport & Company

Last question. How many shares did you repurchase in fiscal 2008?

K. Douglas Ralph

In fiscal 2008 it was around 7.1 million shares in fiscal 2008.

Timothy Hayes – Davenport & Company

Thank you. That’s all I have.

Operator

Your next question comes from Leo Larkin – Standard & Poor’s

Leo Larkin – Standard & Poor’s

Good morning. Could you just remind us what CapEx will be in this fiscal year?

Anne L. Stevens

CapEx for the year is $125 million. The bulk of that expenditure is obviously on the premium melt project. I will tell you we are looking at all other expenditures and are just basically spending what we need to spend. It’s under review. It could be a bit less than $125 million, but the bulk of it will be spent to complete the premium melt project.

Leo Larkin – Standard & Poor’s

Okay. Would that represent sort of an interim peak, if you will? Other things being equal. So that 2010, barring any new project –

Anne L. Stevens

Yes.

Leo Larkin – Standard & Poor’s

Okay. Thank you.

Operator

Your next question comes from Bob Fetch – Lord Abbott.

Robert P. Fetch – Lord Abbott

Good morning. In regard to the shares purchased in 2008, what were they purchased at in terms of capital dollars employed?

Anne L. Stevens

Give us one second.

K. Douglas Ralph

Yeah. Our total cash deployed against share repurchase in 2008 was $425 million.

Robert P. Fetch – Lord Abbott

Okay. And then in regard to the Boeing strike to the extent that it may be over, how long do you think the lingering effects may be?

Anne L. Stevens

I’m not really sure at this point. It’s obviously something that we’re looking at and not sure.

Robert P. Fetch – Lord Abbott

Okay. Knowing that mix is important, what might you consider to be your current break even quarterly sales rate? Or annual. However you want to look at it.

K. Douglas Ralph

We haven’t done an analysis to be able to answer that in a specific way. What I would say in a general way is that because of the changes made in the company’s debt and fixed-cost structure earlier, just after 9/11 in the decade and then the recent ones that we’ve made here, we can absorb most realistic downturn scenarios and still be positive cash flow. The company’s top line was impacted by 25% or 30% following 9/11. So just as a couple data points there.

Robert P. Fetch – Lord Abbott

So when you made the comment earlier that it’s too early to predict the economic impact but confident that management can profitably manage the business through this period you would not be looking to not generate earnings in any given period.

K. Douglas Ralph

Right. It would take a pretty significant downturn in order to put us in that area.

Robert P. Fetch – Lord Abbott

Okay. Can you speak to any new customer additions or important products that will be contributing to growth over the next year to three?

Anne L. Stevens

Yeah. Obviously we’ve got quite a few products I’m excited about that I’m not ready to talk about. But some of the products that I can talk about at this point is one that we call Custom 465. That’s an alloy that is a best-in-class stainless alloy, in that category. It’s really characterized with very high strength and corrosion resistance. It’s being used in a lot of weight reduction applications. In the environment where everyone is sensitive to overall costs it has been attractive and it’s even being more attractive because in effect what we see with that product is it’s being applied in aerospace both structurally and with fasteners. It’s also seeing some application in medical and even in the sporting goods sector. That’s one product that we have.

We also have some other really exciting products that are being developed for both the oilfield as well as nuclear waste disposal sectors. There’s quite a bit more on the drawing board. Back about two months ago we strengthened our research and development staff and brought in Tim Armstrong from the Oak Ridge laboratories. So we’ve got a lot of exciting projects going on internally, as well as some collaborations with external labs and external universities.

Robert P. Fetch – Lord Abbott

And just following that up on nuclear waste. Is that for, say, vessels that would contain the waste?

Anne L. Stevens

That’s correct. We’ve got some patented products that are very, very effective in that arena. Some of that work is open work and obviously some of that work is classified.

Robert P. Fetch – Lord Abbott

And I guess those vessels would have long lives to them, if not infinite?

Anne L. Stevens

Yes, that’s correct.

Robert P. Fetch – Lord Abbott

Okay. In regard to the auto business, the decline that we’ve seen, does that sales run rate reflect kind of the sales run rate as they’ve been reported largely? Or were there some inventory adjustments, do you believe?

Anne L. Stevens

I don’t think they’re inventory adjustments. I just think it’s looking at what in the auto industry they call SAR. I can remember having come from that industry we had a couple running rates in the US market of annual rates, that’s what a SAR is, of 17 million to 18 million new production units. The SAR rate now is roughly 12 million units and could go lower.

Robert P. Fetch – Lord Abbott

So where we’re at right now you probably have a few more quarters where sales and automotive could be down roughly plus or minus a third?

Anne L. Stevens

I’m not really sure that I can determine that because the other thing that obviously will impact that is how much inventory is in the dealer’s lot and I’m not as close to what the dealer day on hand is today because the other factor that we know is impacting that is the ability of the dealers to not only sell the vehicles but to finance the vehicles. I’m not close enough to that situation. I do know and can tell you what happens when that supply inventory on the dealer’s lot gets very excessively high then the domestics take incremental production shutdowns. I think we’ve seen some announcements just the past couple weeks with some production cuts, both temporary and permanent, that GM has taken.

Robert P. Fetch – Lord Abbott

And of your auto sales, do you have a good handle on how much is big three versus non-big three or transplant?

Anne L. Stevens

We do sell to suppliers that supply to global markets. The majority of our sales today are in the domestic fleet. Obviously this is something that Sanjay Guglani, our chief marketing officer, along with Jaime Vasquez, who we had announced as president of Asia Pacific, as well as Martine Therese, who is in Europe, are working on diversifying our footprint so we can capture volume more to our international customers. But as of today it is high percentage domestic.

Robert P. Fetch – Lord Abbott

But does that include transport, transplant production in North America or are you speaking just the OEMs that are domestic?

Anne L. Stevens

It’s predominantly, although not solely, the old big three. The domestic big three.

Robert P. Fetch – Lord Abbott

Okay. To the extent and knowing there’s lack of predictability, can you give us some sense on some of your raw material input costs, whether it’s nickel, titanium, etcetera, and say an expectation in the next three to twelve months?

Anne L. Stevens

I wish I could tell you what I expect on that arena. I can give you some numbers that we’ve got on current raw material prices. This is as of 10:24. The numbers fluctuate a bit. The LME had nickel at $4.45 a pound. Cobalt was at $30 a pound. Molly, $33.10; that’s average September price. And pherochrome, which is a very, very important product that goes into many of our alloys, was at $2.14 a pound.

Looking forward, I am really not a good predictor of that. If you had asked me six months ago if we would be seeing nickel in the $4 range I would have said no. So I just do not have the expertise to predict what’s going to happen with these particular raw materials.

K. Douglas Ralph

The Canadian prices are running around $12 or $13 a pound.

Robert P. Fetch – Lord Abbott

Okay. And lastly, can you update us on what your expected CapEx and depreciation are for the year and what you measure as a return on invested capital or, excuse me, cost of capital?

K. Douglas Ralph

As Anne said earlier, we still are anticipating spending as much as $125 million in CapEx this year, although we are looking through each of the projects and may trim back on some of the lower priority projects. But $125 million is the amount that we have put out there and will stay with in terms of current year capital spending. Our depreciation and amortization for the year we would expect to be a shave under $55 million. Our capital projects, you know, there’s a variety of those from capacity projects to cost savings projects to safety and maintenance type projects, but our blended rate of return would certainly be something that we would look to be north of our cost of capital. So north of 10% or 11%. Although in order to keep R&A moving positively forward a return greater than that will be necessarily in terms of cash deployment.

Robert P. Fetch – Lord Abbott

Thank you.

Anne L. Stevens

Okay. I think that is all of the questions in the cue. I thank you very much for the attention that you paid and the questions that you asked us. So as always, we sincerely appreciate your interest in Carpenter and we look forward to talking with you after our next quarter.

Operator

Thank you for attending today’s conference. This concludes your presentation. You may now disconnect. Good day.

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Source: Carpenter Technology Corporation F1Q09 (Qtr End 9/30/08) Earnings Call Transcript
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