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Carpenter Technology Corporation (NYSE:CRS)

F3Q 2012 Earnings Call

April 25, 2012 9:30 AM ET

Executives

Mike Hajost – Treasurer and VP, IR

Bill Wulfsohn – President and CEO

Doug Ralph – SVP and CFO

Mark Kamon – SVP, Specialty Alloys Operations

Sanjay Guglani – VP, Performance Engineered Products

Dave Strobel – SVP, Global Operations

Analysts

Steve Levenson – Stifel Nicolaus

Gautam Khanna – Cowen & Company

Chris Olin – Cleveland Research

Josh Sullivan – Sterne Agee

Dan Whalen – Auriga USA

Phil Gibbs – KeyBanc Capital Markets

Doug Thomas – JET Investment Research

Mark Parr – KeyBanc

Alex Cook – Voyant Advisors

Tim Hayes – Davenport & Company

Operator

Good morning and welcome to Carpenter Technology’s Third Quarter Earnings Conference call. My name is Chris and I will be your conference moderator for today. At this time, all participants will be in a listen-only mode. After the speakers’ remarks, you will be invited to participate in a question-and-answer session towards the end of this call. (Operator Instructions)

At this time I would now like to turn the call over to your host for today, Mr. Mike Hajost, Vice President of Investor Relations and Treasurer. Sir, you may proceed.

Mike Hajost

Thank you, Chris. Good morning, everyone, and welcome to Carpenter’s earnings conference call for the third quarter ended March 31, 2012. This call is also being broadcast over the Internet.

With us today are Bill Wulfsohn, President and Chief Executive Officer; and Doug Ralph, Senior Vice President and Chief Financial Officer. Also participating on the call are Dave Strobel, Senior Vice President of Global Operations; Mark Kamon, Senior Vice President of Specialty Alloys Operations; Andy Ziolkowsk, Senior Vice President of Latrobe Operations; and Sanjay Guglani, Vice President of Performance Engineered Products, as well as other members of the management team.

Statements made by management during this conference call that are forward-looking statements are 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, 2011 10-K, September 30, and December 31, 2011 10-Q and the exhibits attached to those filings.

I will now turn the call over to Bill.

Bill Wulfsohn

Thank you, Mike and good morning, everyone. This is a very exciting time here at Carpenter. And I am very proud of what the team has accomplished this quarter. In summary, we’ve posted another quarter of strong results. We also closed on the Latrobe transaction and we took steps to increase production capacity which will enable near and long-term growth.

Before Doug gives you details about our operating results, I would like to take a few moments to comment on each of these three areas. Let me start with the results of our legacy Carpenter business. In summary, our end-market demands remain strong. Within Aerospace, we are experiencing continued strong demand for super alloys used in aerospace engines, significantly increased demand for our titanium, nickel, and stainless materials used for fasteners and we are seeing increased participation in aerospace structural applications.

More specifically we are seeing higher adoption of our proprietary customs series of stainless materials for flap track, engine mounts, landing-gear components on new platforms such as the A380, A350, 747-8, 787 and the future 737 MAX. In addition Latrobe’s portfolio broadens our participation in complementary aerospace applications such as commercial landing-gear and bearing steel.

Within Energy, there remains strong demand for our materials used in oil and gas explorations as directional drill rig activities remained high. And it is now shifting from natural gas to oil exploration. We also see increased demand in materials for industrial gas turbines. And finally, as we’ve discussed in past calls, we are diversifying our product offerings within the energy markets.

Note, we are also seeing good growth and movement for higher value product opportunities in other strategic areas such as transportation, plus in the act to get the demand for our premium product has enabled us to sustain a very strong backlog. In addition to our strong end-market demand, we are continuing to see positive impact from our pricing and mix management actions. These actions have resulted in higher average profit per pound, greater overall profitability and we’ve seen revenue growth in the quarter has once again outpaced volume growth.

In summary, we are progressing rapidly to meet our commitment to return to our prior peak level of EBITDA excluding any literal contribution. Switching gears, February 29 was a very exciting day in the history of Carpenter, as we closed on the Latrobe transaction. While the antitrust approval process was long, it gave us time to prepare for an aberration which enabled us to hit the ground running after close.

I am pleased to report that the integration process is going well. Latrobe’s operating results are already accretive to earnings excluding acquisition related costs and we are even more encouraged by the synergies potential of the combination. Finally, during the quarter we took significant action to expand our capacities to support both our near-term and long-term growth objectives.

As previously discussed, we have seen rapid demand growth for our premium products. This is good news but has also taxed our available supply. To address this opportunity in the near-term, we have taken actions to add remelt capacity and address constrains in our Reading operations. And immediately after closing on Latrobe, we move forward with an investment to add three additional VAR furnaces at that location.

Impacts of these investments should result in an incremental 4,000 tons of premium capacity over each of the next two years. We are also well under way to doubling our capacity to produce titanium wire used in aerospace fasteners and expand our powder metal production capacity. Every market indicator combined with our customer discussion solidifies our belief that we are in the early stages of a strong growth cycle in the aerospace and energy markets.

Thus to support further market demand growth over the long-term, we just broke ground on our new Alabama facility that will be capable of producing 27,000 tons of premium products. This facility is scheduled to begin operation in April 2014. This investment will enable us to accommodate more customer demand and offer the markets shorter lead times and improved stocking programs. We also believe this investment will improve the company’s earnings growth power. It is important to note that key customers have demonstrated a willingness to commit along with us by entering into long-term agreements to meet their growing material needs.

To emphasize this point, I want to point out that approximately two-thirds of our top engine and passenger customers have worked with us to establish long-term agreements that extend beyond the start of the Alabama facility in 2014. In addition, beyond meeting these long-term agreement commitments, the additional premium capacity we will build will allow us to capture profitable transactional volume opportunity.

We also believe this project has limited downside risk. More specifically, we expect we will be having less than $10 million of additional fixed costs at the Alabama facility by the startup in fiscal year ‘15 excluding non-cash depreciation. And note that it takes a relatively small amount of volume to offset the impact of these additional fixed costs. And we could be selling significantly more premium products today if we had more capacity available. And that situation is likely to expand in the future. This facility will also generate cost savings on existing volumes due to newer technology and better product flow.

Finally, we are funding this investment largely through existing cash and operating cash flow. So in summary, Carpenter is on a good path with strong momentum in the core business. Latrobe will have a significant positive impacts on our earnings growth profile and we are taking required steps to grow our premium capacity for both the near and long-term, so we can better support our customers and we believe will also lead to a sustain strong and profitable growth and value creation for our shareholders.

I’ll now turn the call over to Doug, who will cover our financial results.

Doug Ralph

Thank you, Bill. We had another good quarter of results. We’ve included the chart and exhibits in our press release that hopefully will help you follow the plusses and minuses this quarter and also going forward. Overall, we delivered earnings per share of $0.69 which included a total of $0.15 from final Latrobe transaction cost and a fair value cost adjustment on beginning inventory that we’ll experience this quarter and next quarter.

Excluding these impacts, we would have been at $0.84. The Latrobe business delivered about $5 million or $0.07 per share from operating results and the impact from share dilution was $0.04. The Latrobe is accretive on an operating basis right from the start we expect. Before I get deeper into Latrobe, I want to highlight our strong performance on the legacy Carpenter business. This is the fifth quarter in a row that we a saw a strong positive spread between our revenue growth rate and volume growth rate and an improvement in our average SAO copper per pound.

This reflects good execution of our strategies that drives premium products growth and improves our pricing and product mix. Our average SAO or mills profit per pound is up over 50% in the past year which was our internal goal and increased by another $0.12 from the second quarter. Overall, operating income on the legacy Carpenter business is still tracking to exceed the 50% improvement goal that we set at the beginning of the year.

In our trailing 12 months EBITDA of about $310 million excluding Latrobe, using the definition that we’ve communicated of operating income, depreciation [ph] and amortization plus non-cash pension expense continues on a pace to achieve our goal of returning to our prior peak level of EBITDA on the early end of our communicated three to two year target.

We are also now off to a good start with Latrobe. It is immediately accretive on an operating perspective and we would like to achieve a goal of overall EPS accretion over the first full-year of ownership including offsetting our total transaction related costs going back to the beginning of the deal last June. This would mean that Latrobe is at least 10% accretive to EPS in fiscal year ‘13. We will have a further fair value cost adjustment on inventory of about $9 million in the fourth quarter, excluding this, we will again be modestly accretive on Latrobe operating results after share dilution in Q4.

Note that there are other purchased accounting adjustments for Latrobe that we are absorbing in our operating results, namely the amortization of asset and intangible write-ups would get about $16 million of non-cash expense in the early years on top of base depreciation at Latrobe of about $10 million. The fair value inventory cost adjustment is currently expected to end after the fourth quarter. As we work with Latrobe, we continue to be confident in delivering net pre-tax synergies of at least $25 million by year three.

This is beyond the immediate interest expense savings and lower tax rate we will realize from the integration of the companies. We expect these synergies to start to show up in our results by this fall with most of the value being achieved within 18 to 24 months. Most of this $25 million in net synergies comes from operations. And the largest single opportunity is for additional premium plant capacity from the existing Latrobe assets as well as three additional vacuum remelt furnaces that we provided for in the deal economics and have already moved forward with.

This provides a critical bridge to meet strong customer demand for premium aerospace and energy products between now and the start of our Alabama facility. Note that once the value for this will choke in our SAO segment results, based on where the shipments occur. Beyond this, there are other opportunities to improve output and reduce cost – the profitable Latrobe business and total mill operating system.

In addition, there are cost savings from purchasing and combining things like insurance coverage and professional fee contracts. Additional synergies from potential footprint overlap will take the longest to analyze and achieve which is why we have the three year timeframe. And we expect to make steady progress improving the average profit per pound across the Latrobe assets in overall melt system as we’ve successfully done on the Carpenter business.

On the other side, we do have some near-term cost to synergies from items like IT integration and strategic studies we will undertake to optimize the integration of the two systems. These were all anticipated in our deal economics which were conservatively developed. And last, we have a list of other icing on the case opportunities beyond this that we will pursue in due course.

Net, we are confident in achieving at least our communicated levels of synergies on the deal but some of the part of this realized during the course of fiscal year ‘13. With all of that as background, let me now take you through our third quarter results. Net sales in the quarter were $540 million or 16% above a year ago. Excluding raw material surcharge, sales were up 24% on 10% higher volumes. Without Latrobe, sales ex surcharge were up 13% on flat overall volumes.

By product slab, excluding surcharge special alloy sales increased 13% on 6% higher volumes and stainless steel product sales increased 17% on (inaudible) higher volumes with our focus on premium tons output and product mix management. Titanium product sales increased 11% on 1% lower volumes. Our powder metal sales decreased 8% on 16% lower volumes due to the European force into that business. And finally alloy and tool steel sales and volume both increased over 200% due to the addition of Latrobe.

Continuing down the income statement, gross profit was $105 million, compared with $73 million in last year’s third quarter. The higher gross profit level was driven by a significantly higher profit per pound due to an improved product mix and higher price in the inclusion of Latrobe. SG&A expenses for the quarter were $41.5 million or 9.9% of revenue excluding surcharge compared to $37.9 million or 11.2% last year.

This 1.3% reduction in SG&A is consistent with our strategy to control overhead cost growth to well below the rate of revenue growth. The higher spending mostly reflects the addition of the Latrobe overhead costs. We had $7.9 million of Latrobe transactional cost in the quarter which we were telling as accepted line item on the income statement. This relates to final legal and investment banking costs and a $5 million liability related to the agreed FTC remedy to transfer assets and purchase equipment for Eramet to produce two specific alloys.

Operating income for the quarter was $55.7 million compared with $35.2 million in last year’s third quarter. Our operating margin excluding surcharge and pension EID, as we always quoted was 14.2% or 16.8% excluding the Latrobe acquisition related costs. This compares to 13% in last year’s third quarter. Interest expense in the quarter was $5.6 million compared to $4.4 million in the year-ago period. This reflects the net income – the net impact of an incremental $150 million of debt from our financing actions last June at a lower overall average interest rate.

We fully paid off Latrobe’s debt exposing so we will have no increase in interest expense from the transaction. Finishing up the income statement, other income of $1.7 million for the quarter compared to $1.1 million last year. The provision of income tax was $18.8 million or 36.3% of pre-tax income. This compares to an unusually low $3.1 million or 9.7% of pre-tax income in last year’s third quarter. The tax rate this quarter reflects the non-deductibility of some Latrobe transaction costs and the state tax provisions.

We expect our full-year book tax rate will be about 36% and our cash tax rate on the other hand is only 11%. Overall reported net income was $33 million or $0.69 per share as previously discussed this consists of $0.84 a share from the continuing business partially offset by $0.15 of Latrobe acquisition related costs. Net income in the third quarter of last year was $28.6 million or $0.64 per share.

Looking at the segments on an ex surcharge basis, specialty alloy operations or SAO sales increased 12% on 1% lower volumes with operating income of $66.7 million and a 21.5% segment operating margins. Performance Engineered Products or PEP sales increased 21% on 8% lower volumes with operating income of $9.8 million and an 11.6% operating margin. Latrobe reported segment operating income of $2.9 million for the month of March and a 5.8% operating margin but adjusted for the inventory fair value cost adjustments and other items adjusted operating profit was $5.1 million with a 10% operating margins.

Free cash flow for the quarter was positive $9.6 million which included a $11.5 million for the Latrobe transaction. We still expect positive free cash flow in the fourth quarter and modestly negative overall free cash flow for the full fiscal year. We have been reducing our inventory levels and have made good progress in some areas but it is a higher business priority right now to maximizing our output in the near-term, to accommodate more customer demands and enhance our stocking programs to reduce customer lead times.

We still expect to see a further reduction in inventory in the fourth quarter and believe inventory reductions between the Carpenter and Latrobe systems is an opportunity area that we will put focus on as part of the integration process. We still expect total capital spending for the fiscal year between $175 million to $185 million. For the next two years, this will increase to about $300 million a year due primarily to the investment in our new Alabama facility.

As we’ve said previously, our CapEx investments intents funding obligations over the next two years will result in overall modest negative free cash flow. (Inaudible) our capacity expansion investments are an essential response to the strong market demand from our customers. We anticipated this level of near-term CapEx investments in our financing actions last year and our growth plan as self-funding with no external credit market risk. Once we are past this peak investment phase, the company should be turned to being a strong cash generator over the balance of the decade.

In terms of our balance sheet, we continue to have sufficient liquidity and anticipate very little if any needs that have our $350 million revolver. Our other balance sheet metrics have constrained with the addition of Latrobe’s EBITDA and no incremental debt. We currently intent to pay off the $100 million of debt matures next May and did an upsized bond offering last June in anticipate of this.

Finally I’ll end with a few comments on our outlook for earnings next fiscal year. As we close out fiscal year ‘12, we are on track to grow our operating income excluding non-cash pension EID of about of $100 million or over 70% including the reputation of Latrobe. For fiscal year ‘13 our early thought is that we believe we can achieve a further increase in operating income ex pension EID of at least 30% and an additional $70 million.

Latrobe on its own will be about 10% accretive to EPS even considering the $16 million in additional non-cash expense due to purchase accounting impact on asset and intangible depreciation and amortization. We are currently using $59 million or $0.76 per share as our estimate for pension expense including Latrobe next year with about $22 million of this on the pension EID line (inaudible) locked in until the asset value and interest rate assumptions at the end of June, so we’ll continue to keep you updated on these estimates.

And we are estimating a combined fiscal year ‘13 tax rate of 34%. Beyond this, we are taking actions including creating more near-term premium products and capacity to continue the strong earnings progress into fiscal year ‘14 and then we have the Alabama facility capacity kicking in beginning in fiscal year ‘15. Taking all together, we are bullish as we can sustain strong revenue and profit growth through the rest of the decade with our four business growth opportunities, the Latrobe execution and synergies, the additional Alabama capacity and other growth strategies including new product initiatives.

We are planning an Investor Day in New York City on the morning of September 7, when the management team can take you through all of this in more detail. And with that let me now turn it back to operator, so we can open the line to your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from the line of Steve Levenson with Stifel. You may proceed.

Steve Levenson – Stifel Nicolaus

Thanks, good morning everybody.

Doug Ralph

Good morning.

Bill Wulfsohn

Good morning.

Steve Levenson – Stifel Nicolaus

Could you talk a little bit about how pricing on nickel based super alloys works relative to capacity, and what if any relationship it really has with LME nickel prices?

Mark Kamon

This is Mark Kamon. The pricing on nickel alloys for our business occurs in two different ways primarily. We have transactional business and we have what we call annual contractor long-term agreements, where we have price arrangements. So on our transactional business and on our LTA business, we have hedging and/or let’s call it a raw material surcharge strategy that moves with nickel, so as nickel moves up and down, that responding action moves up and down. So we think over time we’re neutral as nickel moves.

Steve Levenson – Stifel Nicolaus

Okay, thanks. And then in relation to the transactional business, not subject to long-term agreements, I guess what as you continue to use up the capacity, you’re able to raise those prices?

Mark Kamon

Sure. That’s – there is supply demand, than it is on transactional business but we’re also are looking to grow our new products and use our capacity to enhance our customers’ ability to compete and complete as well.

Steve Levenson – Stifel Nicolaus

Got it, thank you very much.

Operator

Our next question comes from the line of Gautam Khanna with Cowen & Company. You may proceed.

Gautam Khanna – Cowen & Company

Hi, thanks great results guys.

Doug Ralph

Thank you.

Bill Wulfsohn

Thank you.

Gautam Khanna – Cowen & Company

So could you talk about a couple of things. First, I think you were doing a study on the fastener side of the business to see what actually is going on. So could you clarify what you’re seeing with respect to nickel stainless and titanium fasteners? And then I have a couple of follow-ups.

Sanjay Guglani

So for the titanium – this is Sanjay Guglani.

Gautam Khanna – Cowen & Company

Yes.

Sanjay Guglani

For the titanium fasteners, we are seeing increased demand from most supply chains. There are some isolated sections of the supply chain where the take up is not that fast. And I would say that is true for both nickel and titanium.

Gautam Khanna – Cowen & Company

Could you comment really on the differences between Boeing and Airbus?

Sanjay Guglani

So our perception is that the Airbus supply chain is pulling materials on a consistent basis. It seems that on the Boeing supply chain, they might be isolated incidence of burning down of excess inventory from previous build ups on titanium side. On the nickel side...

Mark Kamon

Yes, on the nickel side of the business – this is Mark again. On the nickel side of the business, as we’ve reported over the last few quarters, we’ve seen significant double-digit increases in fastener demand and that continues through the third quarter as we’ve just experienced. And we comment in general that when you think about fasteners, the fastener demand is really a function of the number of planes that are rolling off at the end of assembly line over a long period of time.

So the number of planes is growing and the size of those planes is growing. So we should see consistent fastener growth consistent with the airplane builds and we’ll see from time to time some quarters that are higher in demand and some quarters that are little lower but growing steadily further as we go through the decade.

Gautam Khanna – Cowen & Company

Mark, I mean to follow-up on that, are you seeing any differences between the major fastener OEM, I mean because obviously Boeing went for these new long-term agreements January 1, and presumably shifted share along the way and I just wanted if you’re seeing any notable differences between the three major?

Mark Kamon

I couldn’t comment on the nature of their business because I don’t know the details internally, but sufficed to say our overall fastener demand, we participate with the entire fastener community, continues to grow.

Gautam Khanna – Cowen & Company

Okay. The other thing, Doug, you mentioned inventory I think the step up goes away in the September quarter, so is that at zero, I thought it was going to be over six months, did I hear you right?

Doug Ralph

Yes, we’re anticipating the beyond the charge that we booked this quarter similar $3 million a month, $9 million-ish type of charge in the fourth quarter and really then it becomes a function of – this is part of LIFO nickel pool. And when we’re reducing inventory, we’ll have these kind of cost impact, but if inventory is leveled to increase and we wouldn’t – and right now we would not anticipate having any carryover of the inventory cost adjustment into our fiscal year ‘13 or back in September quarter.

Gautam Khanna – Cowen & Company

Okay. Could you also spring for us, you mentioned 4,000 tons of incremental capacity. Does that relate apples-to-apples to 40,000 that you currently have? Could you just talk about what specifically your premium melt capacity will rise by, first, ex Latrobe and then with Latrobe?

Dave Strobel

This is Dave Strobel.

Gautam Khanna – Cowen & Company

Yes.

Dave Strobel

If you take a look at our premium melt capacity, the key area that is – key two areas that have been inhibiting our growth areas and the remelt capacity is also up. We’re taking some actions within Reading operations to approve that with two ESR furnaces. The first has started up, the second is starting up this coming quarter, and the addition of three VARs out in the Latrobe operations. And that will help from a remelt capacity. The hot work capacity long-term obviously will be the focus facility in Alabama. Short-term we’re making some changes with the products between Reading and Latrobe to open up positional hoppers in that. So between the two operations, we feel very comfort with 4,000 tons FY13 and another 4,000 over FY14.

Gautam Khanna – Cowen & Company

Okay, and lastly just a general one maybe, if you could talk about any areas of the portfolio that are actually softening?

Bill Wulfsohn

Well this is Bill Wulfsohn.

Gautam Khanna – Cowen & Company

Yes.

Bill Wulfsohn

And I would say that it’s not that we’re seeing softening per se, but there are some areas as we’ve discussed in previous calls where strategically we have made the decision that we needed to either get more price or exit certain parts of our business that would be kind of lowering our overall profitability and mix and yet going through constrained operations.

And so you see that in parts of our operations, part of our SAO business. Maybe I would comment that in Europe we are seeing a little bit of softness on the powder side in the marketplace. So that would be one specific case, but beyond that we’re seeing in general strong and robust demand.

Gautam Khanna – Cowen & Company

Thank you guys.

Bill Wulfsohn

Thank you.

Operator

Our next question comes from the line of Chris Olin with Cleveland Research. You may proceed.

Chris Olin – Cleveland Research

Good morning.

Doug Ralph

Good morning.

Bill Wulfsohn

Hi Chris.

Chris Olin – Cleveland Research

Why don’t you just make sure I am clear on the 2013 guidance, the incremental $70 million that does include Latrobe?

Doug Ralph

Yes, it does.

Chris Olin – Cleveland Research

Great. In terms of the nickel based alloys market, is there going to be a time where you could see some type of benefit from contract rollovers or the favorable pricing that seems to be in the market today?

Bill Wulfsohn

Yes, this is Bill Wulfsohn. I would say a couple of things, I mean certainly the dynamics at this point in time have been reasonable for having new contracts and extending contracts, but I really try to emphasize that is what we’re trying to establish is long-term supply relationships with our customers. So there probably is some thought opportunity if you were to take things from more of a transactional viewpoint to push price even harder, but those couldn’t have long-term implications and consequences in terms of our supply relationships to those customers.

So what we’ve been focused on is trying to find what we think are very good returns for our shareholders and very sustainable pricing positions for our customers. And trying to strike that balance accordingly and I think you’re seeing that reflected in our results.

Chris Olin – Cleveland Research

Last question, I have two back at 2013 guidance, does that include a potential impact from the new incremental capacity that you’ve talked about in your market?

Doug Ralph

Yes, it would. But obviously not the focus facility because of the timing that that will come online.

Chris Olin – Cleveland Research

Okay, thanks.

Operator

Our next question comes from the line of Josh Sullivan with Sterne Agee. You may proceed.

Josh Sullivan – Sterne Agee

Good morning, great quarter.

Bill Wulfsohn

Thank you.

Josh Sullivan – Sterne Agee

I know that you said that cash flow is going to be slightly negative as you invest in the new facilities. So kind of in a similar way to how you expect to proceed your previous EBITDA targets, and do you expect cash flows return that kind of 100% knocking income level on the facilities up and running long-term?

Bill Wulfsohn

We will have made the structural investments that we believe will give us significant capacities to meet the demand, the cost of that in for example in the nickel area incremental capacity will be structurally much lower because the base investment we’re making now will not only give us capacity gains but will set the seeds for further growth. We can’t predict what time the acquisition opportunities might be out there and what other types of growth opportunities we would want to pursue, but we believe that from an operating cash flow, we’re making the structural investments right now to get the capacity and capabilities we’re looking for.

And so are any of those other caveats, we should see very strong cash flow coming up from business after those investments are completed.

Josh Sullivan – Sterne Agee

Thanks. And then just kind of that M&A outlook, I mean are you looking more kind of on the energy side, in the PEP segment, where might that be targeting?

Bill Wulfsohn

I think the PEP segment would be the very logical area to extend ourselves. We’re very excited. We feel very good about our momentum but have of course an execution agenda on the SAO portion of the business with integrating Latrobe and expanding our capacity. PEP business is and that’s one of the reasons why we structured it in a separate operating group, it doesn’t have some of those execution agenda, challenges that the SAO businesses face with. So that’s an area which would be very logical for incremental and additional acquisitions.

Josh Sullivan – Sterne Agee

Great, thanks. I’ll get back in the queue.

Operator

Our next question comes from the line of Dan Whalen with Auriga USA. You may proceed.

Dan Whalen – Auriga USA

Thank you, first of all, congratulations on the quarter and the acquisition completion. So on the titanium fastener side which has exceeded prior peaks, where do we sit in terms of the nickel and the stainless, I mean if we were to look at a face of the clock, where are those fasteners sit in terms of the cycle?

Mark Kamon

Well I would see there is a difference in Ti and nickel driven by the aircraft. So if you’re thinking about Boeing staring the 787 production, the 777 increasing some of larger aircraft, the Ti content is much higher, which is why you’re seeing Ti respond faster.

Dan Whalen – Auriga USA

Right.

Mark Kamon

So we’ve seen significant growth on the nickel side, we’re not quite back to peak but frankly it continues to come as I said in double-digit growth, significant double-digit growth quarter after quarter for the last four and we would expect that momentum to continue for some period of time.

Dan Whalen – Auriga USA

And what about the stainless?

Mark Kamon

My comment pertains to both nickel base and stainless, but stainless is a smaller piece of the total I think.

Dan Whalen – Auriga USA

Right, okay. Which – as a follow-up, I mean if we were congregate the titanium, nickel and stainless, can you give us a rough estimate in terms of the contribution in terms of total fasteners?

Doug Ralph

Yes, I am not sure contribution in – this is Doug, contribution in what terms but we…

Dan Whalen – Auriga USA

Yes, if we were to look at – take a look at your total fasteners business, how much is titanium, how much is nickel and how much is stainless?

Doug Ralph

We’ve talked about them all together, aerospace as you know is our largest business representing about 43% of our total revenue and within that, fasteners is about 35% to 40% of that. And we have strong position with majority of market share positions in all three type of fasteners there, and we haven’t really broken down that individually other than what you can infer out of look at our titanium products sales that we report.

Dan Whalen – Auriga USA

Right, okay. Fair enough. And then post-Latrobe, can you remind us what your spot versus contract long-term agreement is in terms of pricing?

Doug Ralph

On what we’ll call the legacy Carpenter business, it’s about 50/50. Where LTA and transactional and then on the Latrobe side, long-term agreement would be a quite a bit of a smaller percentage.

Dan Whalen – Auriga USA

Okay. So your spot business went up on a combined basis?

Doug Ralph

That’s correct.

Dan Whalen – Auriga USA

All right. And then lastly this is maybe in your file and so may ask more, but can you just remind us what Latrobe, what the peak EBITDA levels were?

Doug Ralph

You’d have to refer to Latrobe’s fillings including their F-1, they were private company as you know.

Dan Whalen – Auriga USA

Yes.

Doug Ralph

So all the information on that would in their previous filings.

Dan Whalen – Auriga USA

Okay. Well thank you for the color.

Doug Ralph

Yes.

Operator

Our next question comes from the line of Phil Gibbs with KeyBanc Capital Markets. You may proceed.

Phil Gibbs – KeyBanc Capital Markets

Hi gentlemen, good morning.

Bill Wulfsohn

Good morning.

Phil Gibbs – KeyBanc Capital Markets

So I just want for clarity purposes the guidance that you’ve provided for operating income excluding EID pension, is that on a GAAP basis?

Doug Ralph

Yes.

Phil Gibbs – KeyBanc Capital Markets

Okay.

Doug Ralph

It’s in our operating income and that we report on our GAAP statements and it has the pension EID and that’s the number that we’re referencing.

Phil Gibbs – KeyBanc Capital Markets

Okay. So for our fiscal ‘11 base level is that $132 million!?

Doug Ralph

That’s correct.

Phil Gibbs – KeyBanc Capital Markets

Okay, perfect. And then over the last couple of calls, we’ve thought that inventories were going to come down a little bit in the back half of the year that would, I think would declining nickel creates some sort of LIFO charge, and just looking to see the outlook on that, I know you mentioned it a little bit but did we have a modest benefit in this quarter?

Doug Ralph

We had about a $1 million negative, I mean inventories did come down some and we would expect as inventories come down in the fourth quarter to have a little bit more of a negative impact if that’s your question.

Phil Gibbs – KeyBanc Capital Markets

Yes.

Doug Ralph

Okay.

Phil Gibbs – KeyBanc Capital Markets

Okay. And then last question here for Bill, the PEP sale largely leveled out here over the last three quarters, is that largely because of the powder business?

Bill Wulfsohn

That would probably relate more specifically to the comments I made a little earlier that the powder weakness in specifically in Europe, the business here in North America has been very strong.

Phil Gibbs – KeyBanc Capital Markets

Okay, thanks gentlemen.

Operator

Our next question comes from the line of Doug Thomas with JET Research. You may proceed.

Doug Thomas – JET Investment Research

Thank you. Good morning, I mean outstanding results and I very much applaud the efforts. Quick question, I think it was Doug, who talked of the – your efforts to try to incorporate your customers views and outlooks in terms of the Alabama facility and so forth. And whether its Bill or Doug I guess my question is going forward, you clearly got much more of a customer facing approach to building this business than at any time I think probably I call recall. I am just wondering how that plays out, how much your customers have an interest in involving themselves in the planning for the new capacity and how much of a – over the long-term, what sort of benefits will that accrue?

Bill Wulfsohn

Absolutely and I appreciate you for your question and that the theme you picked up on. We’ve looked at it very carefully and we’ve assessed from a kind of macro trend standpoint what we believe will be the aggregate needs in the marketplace versus the aggregate capacity and availability. So we’re trying to be proactive to make sure that we not only have the needed capacity but also that we have the flexibility to meet if you will certain peak that come with demand without having to extend lead times.

In fact our goal is dramatically shorten lead times by putting in much more lean production processes. And in terms of aligning the capabilities with our customers, we actually are going through a process by which we’re spending a lot of time with our specific customers sharing with them the details of what it is we’re doing and getting feedback from them as to if there are specific enhancements, nuances that could be beneficial from their perspective. So we want to be the best supplier to the industry.

Doug Thomas – JET Investment Research

And then I guess secondarily, I know we’re just coming off the third quarter and people are looking forward to next year but, Bill, again I know that the approach and not a lot of people talk about that but the approach towards aligning management compensation with performance, you’re not going to have a meeting until September by which time there will be another – there will be the proxy out for this year and so forth. But can you give a sort of a state of the nation, sort of just view of how things are working out in terms of the alignment that you’ve put in place there in the last couple of years and what you’re expecting as we head towards next year?

Bill Wulfsohn

Sure, well I think first of all I think we have excellent team and we’ve rallied around the opportunities we have. We work well together but each individual understands their specific contribution to the core success. From an intensive compensation standpoint, in our short-term compensation and you can find this in our CD&A that we’re primarily focused around what we deliver in terms of operating incomes, so very aligned with the shareholders.

We have customer performance and safety performance as part of what’s important for us to deliver. And clearly our long-term incentive compensations are very much aligned to total shareholder returns and stock appreciation. As we look forward to next year, while this is ultimately up to the Board to make the final decision, we’re not looking for our fundamental redesign in terms of our compensation programs. We believe that they are well aligned with the business interest and the shareholder objectives.

Doug Thomas – JET Investment Research

Okay. And I apologize, just briefly you mentioned about there is not really a clear path, I guess, in the near-term to acquisitions or things that you find compelling enough to do here until you’ve integrated, made some of the integration of Latrobe and also new capacity and so forth. Can you talk about pricing is an additional consolidation outside of Carpenter as – are deals – are there some deals out there, what’s going on in terms of pricing of potential M&A?

Bill Wulfsohn

Yes, and I want to be clear maybe I wasn’t before that we are very interested and are active and will pursue acquisition opportunities some times that can be opportunistic because others choose to make transactions available whether it’s on your schedule or not but from a cultivation standpoint, we’re really focused more on acquisitions that relates to the PEP business. And I say that just because of the strong execution focus that we have in the SAO business at this time.

In terms of valuations and pricing of potential deals that are out there, I would only comment that it’s not surprising that given the general momentum in earnings growth and the fairly bullish sentiment around some of the segments that we would be focusing on like energy and aerospace and medicals, that people are looking to not just get their current value and historical value but also what they perceive as a future value of their businesses. So it’s not an expensive.

Doug Thomas – JET Investment Research

Okay, well said. Listen, thank you very much. Congratulations again, I appreciate.

Bill Wulfsohn

Thank you.

Operator

Our next question comes from the line of Mark Parr with KeyBanc. You may proceed.

Mark Parr – KeyBanc

Yes, thanks a lot. Good morning.

Bill Wulfsohn

Good morning.

Doug Ralph

Good morning.

Mark Parr – KeyBanc

So that was a very nice quarter, congratulations. I am delighted just to see the progress. Most of my questions have been answered and I had one longer term question and it would relate to the new facility in Alabama. And once you get that or once you begin commissioning, there would seem like there would be an opportunity to perhaps move I’ll call non-premium, non super premium material from Reading into that operation, and give you another boost to super premium in your existing operations of Latrobe and Reading. Is there any way that you could quantify that for us in terms of what sort of incremental capacity that might create for the high end products?

Dave Strobel

Hi Mark, this is Dave.

Mark Parr – KeyBanc

Hi Dave.

Dave Strobel

You are absolutely correct in that a lot of the product that we hope to eventually have down at the Alabama facility going through there will require vendor qualifications that can take fewer more years. And obviously to get that operations up and running, our plan would be to move products that does not have stringent qualifications but you get turned on very quickly down there and allow us to get operating and free up the capacity then within Reading and Latrobe operations to make more of a vendor proof process, while we’re going through the qualification in Alabama.

And we feel very confident that as we start up that first fiscal year, we are looking at 10,000 tons plus and being able to grow that over four years up to the 27,000 tons. Does that answer your question?

Mark Parr – KeyBanc

Yes, thank you very much.

Dave Strobel

Welcome.

Mark Parr – KeyBanc

And good luck on the June quarter.

Bill Wulfsohn

And this is Bill. I would only just add and we will see indeed versus the word but in the interactions with customers given the relative limitation tons supplied today and the relatively long lead times, we’ve found that customers are expressing a willingness to move from in terms of qualification in a very productive constructive manner with us. So we’re hoping – and especially when the lead times that we’re looking to offer out of the facility based on the lean approach I think there is going to be some very good incentive for customers to move that process forward in what we hope will be a – of course they are responsible but a fairly quick timeframe.

Mark Parr – KeyBanc

Thanks again.

Bill Wulfsohn

Thank you.

Operator

Our next question comes from the line of Chris Olin with Cleveland Research. You may proceed.

Chris Olin – Cleveland Research

Hi, I just wanted to follow-up on the 2013 guidance once again just to make sure I understand where you’re coming from. If I take the SAO EBIT number of $66 million annualized, let’s just say $70 million, I get $280 million in 2013. So that’s incremental about $45 million presumably Latrobe, I’ll just say $30 million to $40 million, that’s $70 million incremental there. And that’s just considering all the numbers hold relatively flat. Am I missing something, are you expecting some type of margin erosion next year or is there something in the numbers that were skipped, it should be that conservative?

Doug Ralph

I mean you’re going a little too quick for me there on the math and the different pieces there but the direct answer, do we expect erosion in any of the pieces. No, we did expect continued progress on our SAO process, on our PEP businesses and with Latrobe. So I’d have to spend some more time in the way that you kind of laid it out your construct with the goal that we’ve established there would represent progress on all three fronts.

Chris Olin – Cleveland Research

Have you – did you provide what the average middle lead time is right now versus the fourth quarter?

Bill Wulfsohn

We’re actually looking some orders out into the end of the calendar year at this point, so we remain very strong as far as the demand. But again as we free up the capacity through the integration efforts that we have, we’ll be able to provide some additional transactional business as we work our way through the calendar year as well.

Chris Olin – Cleveland Research

Okay, thanks.

Operator

Our next question comes from the line of Gautam Khanna with Cowen & Company. You may proceed.

Gautam Khanna – Cowen & Company

Hi guys, I just want to follow-up on the guidance question. So I just want to be clear and in Q4 we’re estimating, you’ve done a $1.74 year-to-date the implied guidance to somewhere around $280 million. So is Q4 on a GAAP basis somewhere north of a dollar, because I just want to be true, we’re talking to same lines with?

Doug Ralph

I am not sure how to respond to your question Gautam, and the math for Q4 but...

Gautam Khanna – Cowen & Company

Okay, maybe we can just talk about some of the items, so interest expense in Q4 will be comparable to Q3, is that fair around $6 million?

Doug Ralph

We’re not adding any debt to our interest expenses is constant [ph].

Gautam Khanna – Cowen & Company

Is there anything with respect to margins, I mean we saw the PEP margins stepped down a bit, would those rebound, if there is any one-time effect in the March quarter?

Doug Ralph

Yes, I don’t want to get deeply into providing specific guidance in the fourth quarter. I will point out on Latrobe that we do have – well we have $9 million of further inventory cost of effect, did a purchase accounting on Latrobe. So it’s got to be factored into the equation. And share dilution alone in the quarter is probably about $0.12.

Gautam Khanna – Cowen & Company

Yes.

Doug Ralph

So between those two effects, you’ve got say $0.23 $0.24 headwind that we need to compensate for with the Latrobe operating results and the progress on the legacy Carpenter business.

Gautam Khanna – Cowen & Company

Okay. Could you talk about, Kamon, you mentioned the capacity constrains in terms of spot business you were unable to fulfill so far this year, have you – can you quantify for that for us?

Mark Kamon

Obviously we’ve been expanding our premium capacity output and I think that’s a message I just want to emphasize is yes, there are constrains but we are expanding our output in the premium area. Some of that is through mixed management and some of it though the capacity investments that we’re making in the synergies coming from Latrobe. And we expect that to continue. We’ve tried not to highlight that.

Clearly if we had the 27,000 tons that were at the premium facility available today, we think that we would be well utilizing a significant portion of what we’ve said is our first year target for that book. It would be wonderful to have it here today, but as a result, we’ve deferred and had to if you will spend out lead times on some of that business.

Gautam Khanna – Cowen & Company

Okay. And then Doug, could you talk about kind of the cash pension requirements next year, fiscal ‘13?

Doug Ralph

I think we’re looking at roughly it will be our SEC filings, but we’re looking at roughly $55 million on legacy Carpenter and then probably another $15 million on Latrobe, so $70 million in total.

Gautam Khanna – Cowen & Company

Thank you.

Doug Ralph

You’re welcome.

Operator

Our next question comes from the line of Alex Cook with Voyant Advisors. You may proceed.

Alex Cook – Voyant Advisors

Good morning. Could you speak about the drivers of the increase in inventory?

Bill Wulfsohn

Sure. Actually we have been working progressively bringing inventory down and we expect to continue that through the fourth quarter through just overall management but what we have done overtime is we’ve specifically built up some of our stock programs, some of our intermediate materials so that we can try to have the flexibility to provide responsiveness back to our customers given that we have relatively longer lead times. In addition to that, we’ve had almost $25 million worth of increase in the value of our inventory just as a result of the fact that there is a richer mix of products that we’re selling at this point in time.

So both of those fasteners are contributing to build up between the first half of this year and now we’re working to bring that down. But again responsiveness is the priority right now.

Alex Cook – Voyant Advisors

And then how much of that is related to the Latrobe acquisition?

Bill Wulfsohn

Well there has been really, I would say very, very little as a result of the Latrobe acquisition. Now that we’re working together after the close, we’re obviously running some qualification runs of their product, some of the Reading facility and vice versa. So there might be some incremental effect but we wouldn’t point to that as a major driver.

Alex Cook – Voyant Advisors

Okay, thank you very much.

Operator

(Operator Instructions) And our next question comes from the line of Tim Hayes with Davenport & Company. You may proceed.

Tim Hayes – Davenport & Company

Hi good morning.

Bill Wulfsohn

Good morning.

Tim Hayes – Davenport & Company

Just to clarify on back on Latrobe and the impact from the inventory write-ups. The reported operating income was $2.9 million and how much of the – was there from the inventory write-up in that $2.9 million?

Doug Ralph

It’s the same number, Tim, $2.9 million if you look at one of that schedules in our press release, it breaks out that the getting from a $2.9 million Latrobe segment operating profit backing out the $2.9 million it’s due to the inventory write-up and then some other adjustments in getting to the little over $5 million of Latrobe operating results contribution in the – will both would effectively amounts to a month.

Tim Hayes – Davenport & Company

Okay. So that’s the overall, there is a $2.2 million adjustment?

Doug Ralph

Right. I wish $2.9 million is the inventory item.

Tim Hayes – Davenport & Company

Got it. Okay, thank you.

Doug Ralph

You’re welcome.

Operator

And we have no further questions at this time. I would now like to turn the call back over to the speakers for any closing remarks.

Mike Hajost

This is Mike Hajost. Thank you, again, for participating on today’s call. We look forward to speaking with you again next quarter. Thank you and Goodbye.

Operator

Ladies and gentlemen that concludes today’s conference. Thank you so much for your participation. You may now disconnect. Have a great day.

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