Good morning, and welcome to the Carpenter Technology Corporation Second Quarter Fiscal 2018 Financial Results Conference Call. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Brad Edwards, Investor Relations. Please go ahead.

Thank you, Operator. Good morning, everyone, and welcome to Carpenter's earnings conference call for the second quarter ended December 31, 2017. This call is also being broadcast over the Internet along with presentation slides. Please note, for those of you listening by phone, you may experience a time delay in slide movement. Speakers on the call today are Tony Thene, President and Chief Executive Officer; and Damon Audia, Senior Vice President and Chief Financial Officer. Statements made by management during this earnings presentation that are forward-looking statements are based on current expectations. Risk factors that could cause actual results to differ materially from those forward-looking statements can be found in Carpenter's most recent SEC filings, including the company's report on Form 10-K for the year ended June 30, 2017, Form 10-Q for the quarter ended September 30, 2017, and the exhibits attached to those filings. Please also note that in the following discussion, unless otherwise noted, when management discusses sales or revenue, that reference excludes surcharge. When discussing operating income, that reference excludes pension earnings, interest and deferrals, or EID. When referring to operating margins, that is based on sales excluding surcharge and operating income, excluding pension EID. I will now turn the call over to Tony.

Thank you, Brad, and good morning to everyone on the call today. We'll begin with an update of our safety performance on Slide 4. Our total case incident rate, or TCIR, was 1.0 for the first half of fiscal year 2018, which puts us on track for our best fiscal year performance in the last decade and likely, the best performance in Carpenter history. In addition, our PEP organization worked the months of November and December with 0 recordable injuries, which reinforces our message that a 0-injury workplace is attainable. While TCIR is how we measure our safety results, our safety performance goes well beyond this lagging indicator as we continue to invest in our future by developing our employees and focusing more on leading indicators. Almost a year ago, we launched a new safety strategy focused on three key areas, leadership, systems and engagement. Our leadership development program teaches skills to our leaders to help them actively listen and understand their team members. As for systems and engagement, we implemented an extensive human performance program that reinforces tools, practices and methods to reduce or eliminate errors in safety, quality and manufacturing. The engagement efforts have helped to empower every employee to stop any activity that they consider unsafe. Our safety culture has progressed to the point where, instead of just measuring results, we are focused more on leading indicators and systemic prevention. Let me give you some examples. So far this year, our employees have identified and implemented 637 hand-safe solutions, which has led to a 55% reduction in hand injury cases year-to-date, issued 3,179 stop cards with detailed actions assigned and tracked to closure and conducted 3,742 one-on-one employee safety reviews. Each employee has a voice and plays a part in the safety culture, and we want to…

Thank you, Tony. Good morning, everyone. Turning to Slide 8, and the income statement summary. As Tony mentioned, we delivered solid operating performance on our fiscal second quarter, marked by healthy year-over-year gains across all end-use markets with sequential performance largely in line with our plan. The underlying fundamentals of our business continue to improve. Our second quarter performance was driven by continued strong execution of our commercial strategy and the ongoing implementation of the Carpenter Operating Model, combined with improving market conditions across multiple end-use markets. Net sales in the second quarter were $488 million, or $416 million excluding surcharge. Sales excluding surcharge increased $5.7 million on a sequential basis on approximately 5% lower volume as we benefited from improved mix mainly associated with our medical as well as Aerospace and Defense end-use markets. On a year-over-year basis, sales excluding surcharge increased 13% on a similar gain in volume. Sales rose across all five of our end-use markets, with 3 of our markets posting double-digit increases and again, exceptionally strong performance in the medical end-use market as we continue to gain share in a strengthening market. SG&A expenses increased by $1 million on a sequential basis and were in line with our expectations at approximately $45 million. We expect our SG&A expense to be at the higher end of our range of $45 million to $47 million on a quarterly basis during the balance of fiscal year 2018. Operating income as a percent to sales was 9.9% in the quarter when excluding pension EID. This was effectively flat compared to the 10.3% in the first quarter. The higher margins associated with the richer mix sold in the quarter was offset by temporary headwinds related to a raw material surcharge lag that I will elaborate on in a moment. Compared…

Thank you, Damon. A primary component of our transformation has been solidifying our position as an irreplaceable partner for our customers. Achieving that goal is dependent not just on our capabilities and teams today but on continuing to innovate and strengthen our solutions portfolio to address the future of our industry and our markets. This strategic mandate will position us at the forefront of enabling customer success in the years ahead. I've spoken on prior calls about a sharp focus on additive manufacturing, given its tremendous disruptive potential and the many attractive growth opportunity it presents across each of our end-use markets. Today, our customers are increasingly exploring additive manufacturing as they seek a higher level of performance for their products, given the growing premium being placed on light weighting, strength to weight, corrosion resistance, heat resistance, improved design and other performance requirements. We bring extensive knowledge in critical areas including powder flowability, process control and next-generation alloy development. Through a combination of existing capabilities, capital investment and strategic partnerships, we believe we can provide customers with solutions from concept through design and ultimately, to manufacturing that can take the performance of their products to the next level. To accelerate our advancement in this space and to provide our customers the solutions they will need to win, we are finalizing our plans to establish an additive manufacturing technology center. This is a critical step to help us evolve in a rapidly changing environment and will provide our customers an opportunity to leverage this innovative technology and our expertise. As excited as we are about additive manufacturing, we are equally passionate about our growing position in soft magnetics. Soft magnetics are not new to Carpenter. In fact, our advanced soft magnetics portfolio, including our Hypocore family, has an industry-leading position in…

[Operator Instructions]. Our first question comes from Gautam Khanna with Cowen and Company.

A couple of questions. First on SAO, you mentioned the raw material volatility. Could you elaborate on what specifically -- how much of a damper that was on EBIT in the quarter? And was that more -- something that affected the cost position of the company versus the price and effect? Or was it actually not stimulative to demand?

Yes, I think [indiscernible] yes, Gautam, no impact on demand. As Tony alluded to in his remarks, demand remained very strong for us in the quarter. The impact was to our cost base. And as I tried to elaborate in my scripted remarks, there's a timing difference with a subset of our customers here, given the cause that we incurred the nickel or the cobalt in, and then when we subsequently surcharge or what price of the surcharge they pay against, so again, for a small percentage of these customers, given that nickel and cobalt was pretty volatile in our second quarter and into January, it created that timing disconnect which impacted our quarter by about $3 million. So if you just added that back to the -- to SAO's margins or to the SAO OI, you sort of see what it would look like under a more normalized percent or idea.

Okay. And then the fire at Dynamet, does that have any impact on the ability to deliver product in fiscal Q3? Or what is that $4 million to $5 million operating impact? Does it -- is it something related to lack of ability to deliver? Or is it just the cost of fixing things? And is that insured?

Yes. So, Gautam, so the fire impact is about 10% of Dynamet's revenue, the product is about 10%. So 90% of Dynamet's running sort of normal, no issues on the customer. The team is working to find alternative ways, so it may be moving products to different parts of the Carpenter facilities. There may be some outsourcing for part of the process. And that's when we talked about, so I'll call it a more costly process to deliver on the customers. But again, there should be relatively minimal impact over the next couple of quarters as we work to deliver the customers' products. The net $4 million to $5 million that I referred to is effectively -- a lot of that is sort of the period cost. So we have some asset write-offs. Again, there was some equipment in the building damaged, so we have to write that down. There is some restoration cost and some cleanup cost. So that's what we sort of expect in this quarter as we move into the profit or the incremental cost of servicing the customers, that will subside over the next couple of quarters. As I alluded to in my remarks, we expect the impact in Q4 to be significantly less. And then the last point to your question is, we do have insurance. We would expect the overall cost of this to be relatively minimal, basically down to our deductible. But the timing of that insurance recovery may not match the cost that we're incurring here in Q3 or into Q4.

Last question just on fastener demand. You mentioned the order rate picked up a little bit sequentially. What are you seeing across the various end markets for aerospace fastener demand by alloy type, the titanium, the nickel alloy and stainless?

Good morning, Gautam, this is Tony. From our standpoint, we just continue to see variability in that market, but I can say that the titanium fastener is stronger than the nickel.

Our next question is from Chris Olin with Longbow Research.

I want to make sure I understand the third quarter guidance for the SAO segment. I think you said up 10% to 15% sequentially. Would I be adding back the $3 million surcharge from the previous quarter on top of that? And then, is there -- how do I think about the surcharge effect for the current quarter?

Yes, so Chris, again, as we alluded to, we're in the month of January -- or we just finished the month of January. So we sort to had to make an estimate on what the surcharge on this lagged component of these customers could be, again depending on where nickel and cobalt and a few other commodities were to move over the next month, so that would have an influence. But in answer to your question, we sort of looked at the $3 million as part of that 10% to 15%, so it's sort of baked in, and to the extent it was less than $3 million, we have moved a little bit up. But if it was up more than $3 million, we'd move a little down.

Yes, Chris, to clarify, I think that we believe we're going to have the same market conditions in the third quarter as we had in the second. So you're going to see that same type of negative impact or close to it.

Is there a seasonal aspect to the demand in the third quarter? I would assume that you guys saw somewhat of an uptick in terms of volumes and revenues.

I think the seasonal argument is history, right? Because manufacturing facilities, as I said in my opening remarks, are effectively full. So we're running 100% across all of our production centers. So the increase in capacity we get or the differences in quarters will be based on our productivity and, quite frankly, the number of days in the quarter. So seasonality just is not applicable in today's market.

Okay. And then just the last question on that. Athens, in terms of that impact on the EBIT number or margins, has that changed at all? And maybe an update on where that is on operating rate perspective right now? I apologize if you already said it.

No, it's a good question. I think a lot of people have some questions, and maybe I'll elaborate just a little bit more on Athens because that is a significant milestone for us, the fact that we are able to deliver qualification packages to the OEMs on the majority of the material that will go through Athens. I think there's just a couple of points that I want to make. First, the qualification process at each OEM is unique. And each one of them is at a different point in the time line when it comes to qualifying Athens. I think, secondly, as we all know, these qualifications are for aerospace jet engines, so by design, the process is painstaking and detailed. But if you take a step back and having said that, there's a couple of points that I'd like to repeat that I said in my comments is that we have seen an increase in expedited orders in this last quarter. Carpenter has stepped up to work with those customers. We understand, had we not stepped up, that engine deliveries would have been negatively impacted. So we have stepped up and will continue to do that. As I said, lead times across the industry are increasing. I can tell you on our key products in this supply chain, we've seen increases in lead times up to 20%, and we believe we're the best in the industry, so we think the others are seeing the same type of increases. As I said, backlog is up, bookings are up. So from where we stand right now, we are actively engaged with every one of the OEMs. We have ongoing regular technical calls and active exchange of information. But where we sit today and what we see, the best I can tell you is that I think it's possible for some of those packages to be approved by the end of this fiscal year. And I'd say we would be hopeful that most would be approved by the end of this calendar year. But I think it is a real stretch to say that you're going to get any margin from those specific aerospace VAP materials in this fiscal year. Now what's important is that, if you remember last quarter, we said that we have now obtained all of our approvals for oil and gas, and that is the recovery market. So I think you'll see increased activity at Athens based on the oil and gas recovery. I hope that answered your question.

[Operator Instructions]. Our next question comes from Josh Sullivan with Seaport Global.

Just on the soft magnetics market. Obviously, you're making a big investment here. Can you quantify that market opportunity maybe today and then what it looks like in 3 years? And I guess, what are the gating factors for maybe achieving some of those targets? Do you need a new design cycle from the OEMs or any qualifications?

Well, a couple of things here. I mean, this is a market that we've been in, I think you all know, over the last several decades. We supply into that market now with our Hypocore suite of products. And I think it's important to say that this is the premium electrical material that we produce. If you ask what's the size of the market, if you look at the addressable market, that means $2.5 billion. Now our base is approximately $50 million, very, very high, very high margins. We believe over the next couple of years we can easily double the size of that, if not more.

And then I'd take that -- I mean, that's higher margin kind of worked from your base? Is that true?

That's correct.

And then just on the $100 million investment. Do you think that will be a greenfield-type operation? Or is that going to be an expansion of your current assets?

It will be an expansion of our current assets, so it would be -- it will go in one of our existing facilities. And it's going to have a time line of about 2.5 to possibly 3 years. I think it's fair to say this is a different type of capital investment than when you're talking about rotary quality disk material that takes a long time to order, to install and then to qualify. Remember, we started the Athens process 7 years ago when we're -- here. These are assets that qualification times are short. We're doing it today. And you have paybacks that are easily 2x the cost of capital. And if you look at our upside and how this market could go, it could be even higher.

And our next question comes from Phil Gibbs with KeyBanc Capital Markets.

The question I had was on the jet engine sales and any color on what you could provide in terms of the growth year-on-year on those sales? And then secondarily, oil and gas?

Okay. So thanks for the question, Phil. On the jet engine side, if you take a look at first half of fiscal year versus first half of fiscal year '17, jet engine revenue was up 8%.

Base sales were up 8% first half over first half?

Correct. And then on oil and gas -- sorry, go ahead.

No, you were going there.

Yes, and then to your question on oil and gas, yes, we see some positive moves there from what we're hearing from the exploration and production companies. Several of those has announced increases to their budget 12% to 16% for 2018. We expect North American onshore to receive the majority of that capital versus the offshore.

And then the growth in your sales there, maybe over the same timeframe as you provided on the engine side?

If I look at -- on the oil and gas side, energy was up 6 -- 7% year-over-year.

That's just oil and gas?

That's energy in total because if you look at oil and gas by itself, it was 60% year-over-year, sorry. But you had a big decrease in power generation year-over-year as you're aware of.

And then the medical sales, I think surprised us particularly, given some of the comments one of your competitors were making about the market. Maybe anything you could provide us in terms of what you're seeing there? And how you've been able to sort of walk the trend? I think you've got growth there and top line of almost 50% year-on-year to date?

Yes, that's a great story. That's about 9% of our market, very strong margins. I think what's important there is where you play. So we're in orthopedic and the cardio solutions. Those are the areas that we're focused on. We've stepped in when some other folks have left the market. The additive manufacturing push has helped us because we sell our wire into that. So I think this is a real testament to the new commercial approach that we've had, and that specific medical commercial team going out and talking to customers that either have been underserved or we've not served at all. And I'd also say on the distribution side, we stepped in there and working with our key distributors to support this market. It's a real growth market for us.

Okay, I appreciate that. And I have just a question on the cost environment. I know you did put an electrode surcharge maybe several weeks ago. Maybe timing or cadence of when you may feel the impact on just the cost base from that? And I know alloys have risen and refractories have risen, freight has risen, so trying to couch how to think about some of that in the model right now and just the business environment overall?

Yes Phil, I mean, the cost for the graph of electrodes, it's going to phase in, and we are already experiencing some of that here in January, again depending on the supply contracts we had and the volume of what we were purchasing from these different suppliers. It's going to sort of phase in, so it's not -- there's no linear or simple answer to that, but it's already starting.

And then my last question is on the inventory. I think you've guided to something down, maybe on a cash basis, $100 million for the balance of the year. Should we think about that as an equal phase in, in Q3 and Q4?

No, Phil, again I think you'll see a little bit -- I think it will be more pronounced in Q4 as you historically see that being our -- generally our strongest sellout quarter.

Our next question comes from Jeremy Kliewer with Deutsche Bank.

Just a question on -- you mentioned the lead times are increasing for some of your engine components. And then, are you guys locked in for contractual pricing? Are you able to also scooch up some of your revenues to match the increase in lead times?

Yes, so we have a majority, I would say, of our -- in that high-end area is based on contracts. But we also have opportunities on shipments that are transactional in nature, and we will take advantage of this type of market.

All right. And then on your kind of year-over-year growth for the last 12 months, how much of that was organic versus being acquired through your peer's acquisition?

It was effectively 100% organic. We've not really had -- the sales that we've had through peers to date are really not material.

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

Thanks, Austin, and thanks, everyone, for joining us today for the second quarter conference call. We look forward to speaking with all of you again on our third quarter call. Thanks, and have a great day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.