Good morning and welcome to the Carpenter Technology Corporation First Quarter Fiscal 2021 Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Brad Edwards with Investor Relations. Please go ahead.

Thank you, operator. Good morning, everyone, and welcome to the Carpenter Technology earnings conference call for the fiscal 2021 first quarter ended September 30, 2020. This call is also being broadcast over the Internet along with presentation slides. Please note, for those of you listening by phone, you may experience a time delay in slide movement. Speakers on the call today are Tony Thene, President and Chief Executive Officer; and Tim Lain, Vice President and Chief Financial Officer. Statements made by management during this earnings presentation that are forward-looking statements are based on current expectations. Risk factors that could cause actual results to differ materially from those forward-looking statements can be found in Carpenter Technology's most recent SEC filings, including the company's report on Form 10-K for the year ended June 30, 2020, and the exhibits attached to that filing. Please also note that in the following discussion, unless otherwise noted, when management discusses sales or revenue, that reference excludes surcharge. When referring to operating margins, that is based on operating income and sales excluding surcharge. I will now turn the call over to Tony.

Thank you, Brad, and good morning to everyone. As we always do, let's start with a review of our safety performance on Slide number 4. Our total case incident rate or TCIR was 0.4 in the first quarter. This marked our lowest quarterly TCIR rate ever recorded. In addition, we achieved our first official injury-free month in the company’s 131 year history during the month of September. A zero-injury workplace is possible and we look forward to achieving our next milestone on our way to zero. Before moving on, I want to take a minute to recognize and thank all of our employees for their ongoing hard work and commitment during these unprecedented times. All of our facilities remain open and operating safely, which is a tremendous accomplishment. Our team has done a remarkable job of building on our core safety value and protecting each other and the communities we’re operating in, while at the same time staying focused on serving our customers. Now let's turn to Slide 5 and review the first quarter. Our first quarter operating performance was in line with our previous guidance as demand headwinds across their end-use markets continue to be the driving factor. Given the current environment, demand weakness is difficult to offset. However, as I stated before, our primary focus is staying cash flow positive. We have taken significant actions which enabled us to continue our strong cash generation performance in Q1. In the first quarter, we generated $63 million of free cash flow and ended the first quarter with over $600 million in total liquidity, including $219 million of cash. In addition, we completed a bond offering that extended our maturities profile and provides us additional financial flexibility as we navigate the current environment. We have ample liquidity to continue managing through…

Thank you, Tony. Good morning, everyone. I'll start on Slide 8, the income statement summary. Net sales in the first quarter were $353 million and sales excluding surcharge, totaled $307 million. Sales excluding surcharge decreased 18% sequentially on 8% lower volume, compared to the first quarter a year ago, sales decreased 37% on 29% lower volume. As Tony covered in his review of the end-use markets, the results reflected ongoing demand impacts driven by COVID-19 headwinds in our key end-use markets of Aerospace and Defense and Medical. This was partially offset by increased sequential demand in transportation, as North American vehicle production rebounded, albeit off a low base from the COVID-19 related shutdowns in Q4. As we've mentioned, since the beginning of the pandemic, we continue to actively manage our production schedules and focus on accelerating a targeted inventory reduction program. While the reduction in inventory drives near-term cash flow generation, which I'll talk about shortly, it negatively impacts our operating income performance. SG&A expenses were $42.3 million in the first quarter, down $11 million from the same period a year ago, and flat sequentially. The lower year-over-year SG&A expenses primarily reflect the impacts of restructuring actions, including the elimination of salary positions, salary furloughs, as well as the impact of remote working conditions that reduce certain administrative costs such as travel and entertainment. The current quarter’s operating results includes $17.9 million of special items. This includes $10 million of restructuring charges, including severance costs, non-cash asset impairment charges and lease acceleration costs. These costs are principally associated with actions that we initiated in the current quarter to reduce costs and streamline operations in our additive business unit. The special items also includes $7.9 million in COVID-19 related costs, included in these costs are direct incremental operating costs, including outside…

Thanks, Tim. Moving to Slide number 13. Our key priorities in the near-term continue to be safeguarding our facilities and employees, maintaining the liquidity and working closely with our customers. While our near-term focus is centered on the execution of those priorities, you cannot turn a blind eye to our future, and the future needs of our customers. During this long history, Carpenter Technology has weathered many downturns, both cyclical and macroeconomic driven, and each time emerged on the other side, a stronger company. Despite these unprecedented times, we believe we have that opportunity again. Today, we remain focused on innovation and creating unique solutions that address evolving industry trends and customer material requirements. To that end during the first quarter, we launched our Carpenter Electrification brand. Electrification is an exciting trend that is changing the way we live in and move around our world. Part of this movement involves electric motors and generators, which are replacing combustion engines in vehicles. This is where Carpenter Electrification plays a significant role. We foresee a rapid increase in the use of electric motor and generator systems in a wide variety of mobility applications. The electric motor is now a well established technology for passenger cars. Electric vehicles have been rapidly gaining in popularity over the last five years and are now a reliable alternative to internal combustion engines. This trend is beginning to take hold in other markets as well, new commercial aircraft already using more onboard electricity to power their systems than ever before. We have seen an increase in hybrid and electric aircraft designs and prototypes over the last few years. In addition, we see similar trends in the defense industry and other markets that rely on mobility and miniaturization, such as drones, autonomous robot and consumer electronics applications. In…

Thank you. We will now begin the question-and-answer session. [Operator Instructions] And the first question will come from Gautam Khanna with Cowen. Please go ahead.

Hi, good morning guys. Thanks for the details.

Good morning, Gautam.

I wanted to just maybe ask you to expand on your comments about kind of the various levels of channel inventory? We have some customers with a year's worth and some that are restocking. Is there any broad trends you can characterize, maybe if you could talk about engine oriented applications versus fast versus other areas, or if there is anything you can expand upon?

Yeah, Gautam, this is Tony. There's really no more additional color there, that cuts across all of our customers. So I wouldn't classify this, the engine customers are the ones that have greater inventory or not. We see variations across whether it's engines, fastener, structural or distribution business in aerospace. So really no difference there Gautam.

Okay. And you know, you guys have talked about how in the second half of the fiscal year, so the March quarter, you'll start to see demand recover. What grounds that view and just curiously, do you have order visibility? Do you have you – what gives you that conviction?

Well, we are very close to our customers spend a lot of time, obviously with our customers. So we have a good line of sight on what we think is going to happen in the second half. And in fact, we just reaffirmed that internally are going through customer by customer, market by market. So I don't think you're going to see a 50% increase in your second half Gautam. I don't think anybody's saying that, but I do think that you'll see an uptick in the third and the fourth quarter. Keep in mind that the first and second quarter has been obviously extremely long. So yes, we're fairly confident that we'll see an uptake in the second half.

I'm sorry to keep belaboring the point, but just to be clear on, magnitude, right now, obviously we're in a destocked period. So it looks like sales levels are below underlying consumption by the end customers. What it should be anyway? Is the right way to think about where the aerospace ex-surcharge sales will shake out, once we get through destocking as 30% or 40% below, what you guys did in fiscal 2019, so we get back to some level obviously below where we were because production rates are down. I'm just curious like in terms of gauging the magnitude of the potential recovery, is that where we should think level out kind of 60%, 70% of where they were pre-COVID to the production rates are down by that level? Or is there some sort of offset to that I can share or otherwise or downside to that because of…

Yes, Gautam. Tough question, obviously. And it's the question that most people are asking. If you just take a look at this quarter on a year-over-year basis, Aerospace is down 45% to 50%. So when does that come back, is it two quarters, is it three, four quarters? I can tell you this that might help you, if you take a look at what we think the second half of the year is going to be, you're probably in that 10% to 15% for a year in that team, a type of recovery that I think you'll see it. I think it's going to be a gradual improvement from there.

Got it. Like 10% to 15% above where we are now. They're about.

Yes. I think that's reasonable. Yes.

Okay. And just last one for me, any changes as you talked about coming to better more mutually beneficial kind of agreements with customers over the mid and long-term, I just am curious what types of things is Carpenter advocating for the kind of minimum – quantity guarantees? Is it better price seem, this is – what are the types of things that you guys are advocating for to kind of, what would you consider better terms?

Yes, it's a good question. We have great relationships with our customers and it really hasn't been what our Carpenter Technology is reaching out to them and dictating this is what we require, in many cases, they're giving us ideas as well. They understand that the good market is going to come back. There is no one we're talking to that said, well, Aerospace is never going to come back. So everyone understands that the market is going to come back, everyone still believes in the macro trend. And they know that Carpenter Technology is only one of a couple of companies that can supply them the materials they need. So it is a very – it's a mutual respect type of relationship and what we're looking for and what they are, in many cases very happy to do, let's extend that contract for a period of time, or let's increase the share that we have on that contract. So it's those types of items that we're looking for Gautam. And quite frankly, don't get a lot of pushback in that area.

Thank you very much, Tony. Appreciate it.

Yes. Thank you, sir.

The next question will come from Josh Sullivan with The Benchmark Company. Please go ahead.

Hey, good morning.

Good morning, Josh.

On the refusal of service, that you mentioned at the aerospace customers for Q3 in prepared marks. What is the tempo of those here in Q4? Does it the same page as Q3 or this is either decelerated or accelerated here?

Well, I made that comment, that's across, I would say that across all the supply chain, it's not just Carpenter Technology. I mean, you can – I'm sure you've heard many times when you have this type of drastic slow down, everyone's trying to conserve cash and many people are trying not to take shipment. So that's happening across the entire supply chain across every level, that is – that's pretty well known. From our standpoint, it's much like the answer I just gave, Gautam, which we work very closely with our customers trying to get to a win-win. And then specifically for us, we've seen that type of activity slow down quite a bit and believe the majority of that's behind us right now.

Got it. And then just on the medical exposure. How do you think that the restocking takes place? You're going to be a snapback as those elective surgeries come back, we might see COVID research here. What are you thinking about the restocking on the medical side and the time, you know, that?

I think that Josh actually a really good question. In my remarks I talked about how we saw an increase in surgery in procedures, but not necessarily a one for one, as far as our supply to them, which tells you that those medical device companies and others in the supply chain or decreasing their inventories, everybody's looking to conserve cash. What we're getting prepared for is that I think you could see a deeper recovery than in the second half as opposed to what you would normally see, because I just don't think there is a one for one right now. I think people are still trying to protect their inventory, especially as we get to most everyone else that the calendar year is the end of their fiscal year. And they're being extra cautious there. So a long way of answering your question to say yes, I think that the spike that you'd see in shipments or demand let's say, or medical could be a little steeper than maybe other markets

Got it. And then just on the inventory draw down between the components where raw materials finished, where are you focused right now? And maybe how should we see that progress? Is it just that second half 10%, 15% kind of looks like if you just walk us through some of the components there and some of the changing dynamics?

Well, there is three big components of raw materials work in process and finished goods, we look at all of those. And I think it's important to note that this inventory draw down, that we're having is not an approach and said, taking inventory out at all costs. It's a very disciplined approach based on our lean manufacturing philosophy. And that is as you well know, just six months ago, we were running at 100% and trying to make as much as possible. So in many cases, yes, we produced inventory or future dates knowing that I was never going to shut down the front-end of my process that had 50 weeks lead times. So our inventory got a little higher than what we would have liked through from – when you're looking at it from the manufacturing point of view. So this has given us an opportunity to continue to work on our productivity and balance our plant and take out that inventory become more balanced. Inventory in many cases is attracted to productivity because it keeps you from working on the right thing. So this has been a very surgical if you will, inventory reduction, I think there's still more that we can do, but obviously, we're not going to take out these level of inventory for the next four or five, six quarters. There will be a time where there were balanced. I think the important thing is Josh, as when you see demand come back, we're not going to put ourselves in a position where you'll have to see a significant inventory build to support that we're going to get down to these levels. We're locking in our productivity and we'll be able to maintain these types of relative levels, even when you see the demand pick up over the next several quarters.

That's very helpful. And then just one last one, you've talked about you're pushing into the electric world, can you talk a little bit about your special alloys there? How do those compare to the current market offering? Is there any way to quantify some of the special attributes that’s very power or some metric while you think Carpenter's going to be successful in those markets?

I appreciate you asking that question because we think this is really important for us. We have our core business that is going to grow over the next several decades, just because of the macro trends. But what we're trying to do is look at other areas of growth in areas that we're already participating in, but we can take it to the next level. And if I could take a step back, in this what we call soft magnetics and running an electric motor, the real key there is that your – the material that you're using that soft magnetic material, it's magnetizing and demagnetizing, on and off. And that's what creates the rotation in the motor. And that's what creates the ultimate power. The material that you use is really important because that material will take the magnetic response or what I said in my prepared comments, the induction. So the higher the induction materials that leads to a better performing motor, that leads to a motor with higher power, higher torque, higher speed. All at the same time, making that motor smaller and lighter, which is really important for electric vehicles, our proprietary product, hyper-coal does all those, and it is rated as the best in the industry right now. So that's why we have a lot of interest for that product. Now, remember, Josh, even before the pandemic, Carpenter Technology was the leader in this area when it came to auxiliary power units in aerospace. We're just taking it to the next level, as the market continues to grow with the electrification of the world. We're moving closer to the customer by not just making material, but moving into stack production and quite frankly, being pulled by our customers to get even more involved. And now as Tim mentioned in his remarks, finishing up the almost $100 million project in our Reading campus to put in a hot strip mill, which will increase the capacity, but more importantly, the capability to produce that product at a lower cost than we do now. And hopefully even, we’ll attract more and more business that way. It's a big market today and it's a market that could be three to four times bigger over the next five to 10 years. So I really appreciate the question that allows us to talk about something that can really be an earnings accelerator for Carpenter Technology over the next year.

Got it. Thanks for the comments.

[Operator Instructions] The next question will come from Phil Gibbs with KeyBanc Capital Markets. Please go ahead.

Hey, good morning, Tony and Tim.

Yes, good morning.

Good morning

Tony, can you give us some color on your backlog, either they change sequentially or year-over-year?

Backlog was down about 18% sequentially that's across all of Carpenter, that's total. Aerospace backlog was down 16% sequentially, on a year-over-year basis, backlog was down about 40%, aerospace backlog was down a couple percentage points higher than that.

That's helpful. And then on aerospace engine specifically what was the either year-over-year or sequential decline in engine revenues?

If you look at engine, you remember last quarter sequentially, it was down 30%. Now we get to this quarter, it's down another almost 40% year-over-year. For this quarter, aero engine is down about 50%. Now, remember to – you're comparing to periods a year ago that were at the high point – over the last five to 10 years, we were at the high point so coming off the top, year-over-year 50% down.

So you're saying year-over-year down 50?

Yes, on aero engine.

Okay. And then I just wanted to be clear on the networking capital side. So this coming quarter, this December quarter, it sounds like it's going to be another strong quarter of taking down your inventories, is that I got that. Just a simple question on that and then I'll ask a part B, is that right?

That's correct. Maybe not the same levels, but we do still see opportunity where we'll be taking inventory out.

So any way to handicap the impact to the P&L just from the loss absorption and in this past quarter, I think you had an EBIT loss in SAO of north of $15 million. If you weren't taking out inventory, just trying to gauge what that intrinsic profit would have been? Would have been closer to break-even if you hadn't been taking out inventory and losing absorption?

Yes. I'll let Tim take that one on where he involved.

Yes, Phil, I mean, I think that's a fair way of looking at it. It certainly would have been closer to break-even or positive. I mean, it really is an absorption impact, as you said. I mean, you've got fixed costs, but that don't go into inventory. And you've also got the variable cost when you're running at lower levels, have a larger impact on your P&L as you're bringing the inventory down. So I think that's a fair estimate directionally of what it would look like this quarter.

Okay. So you had about a plus or minus $20 million hit from under absorption. And then you're also saying you had about $3.5 million hit from COVID costs?

COVID costs, we said we're about $7.3 million. We said included in that $7.3 million is a $3 million bankruptcy impact. So direct cost about four, so just to clarify on that.

So what are – so was that bankruptcy hit – was that bankruptcy hit in your numbers you didn't strip it out?

We added it back for adjusted EPS, but it's in the segment numbers that we were reporting.

Okay. And then on these COVID costs, what – can you just explain what these actually are? And you may have done that, I apologize if you did.

Yes. I mean, sure. We tried to give some high level, it's basically the cost of keeping the facilities going that we wouldn't have, had it not been for COVID it's things like the extra cleaning protocols that we've initiated rentals of equipment and extra PPE for the people in the facilities. There's some aspect of, as people suspect, they have been exposed to COVID-19 or paying them to stay home. And then just kind of other operating supplies for just general protection in the current environment.

Thanks very much.

And the next question will come from Chris Olin with Tier4 Research. Please go ahead.

Hey, good morning guys. Thanks for taking the call.

Good morning, Chris.

I apologize, I got disconnected there for a second, so hopefully I'm not repeating things if I do. Let’s just chalk it up to 2020, but I wanted to just follow up. I heard the tail end of the magnetic Q&A session. And I just want to make sure I understood how – I should think about the timeline. I guess, maybe you'd give me numbers. I've just forgotten, but how do I think about – you were saying demand could be five to 10 times greater and you mentioned earlier end markets that you're looking at. When do we start thinking about those, call them green bananas turning into real volume more than inflection starts. I guess, I'm asking – I was wondering if there was any wiggle room in terms of the CapEx and a timeline for the hot strip mill?

Yes. And just to be clear on that, I said that the current available market to us could be three to four times higher over the next five to 10 years. So not five to 10 times – three to four times higher than – so that's still a big number and I think if you follow this for a long time, you're aware that we've been in this market for quite some time on the APU side with aerospace. And it's just a way for us that fairly broad, I mean, we're moving more and more towards electrification. So, this just takes a proprietary product and now profits and increased equipment into other markets like transportation, defense, and – so consumer electronics. So we're getting earnings and revenue for this right now. And I think over the next several quarters, you'll see that continue to increase. I can't give you a specific time on when that might get to that triple, but I do think it's over the next five years.

Okay. So we're not waiting for anything like the new Tesla plant in Texas or anything like that. It's just a gradual outlook of growth.

I think it's a gradual outlook, but you read all of the source, I mean, more and more companies are moving to this direction. I mean, you saw the announcement from General Motors and what they're going to do, that's significant. Across aerospace, how you could potentially see electric commercial flights, certainly a very small scale. They're doing the testing that now this is going to touch a lot of areas, drones and robotics. And I think we're really at the right point in time here to capitalize on it. And I think the most important point to make really, not only do we have the expertise, we have a proprietary product. And we now within the next three, six months, we'll have our new mill up and running, which is quite an accomplishment. We're getting significant pull from our customers that want us to not only supply that proprietary product, but want us to move further and closer to them in the supply chain, whether that be in the building of stack, what we may or may not do going forward in terms of motors. So it's a really exciting opportunity for us. That is near-term and we'll get the bottom line in the near-term. It's not a decade away.

Okay. That makes sense. One of the – as you take the follow-up pretty closely with the whole product approval process at Athens and I guess, I was wondering if anything has changed since the COVID outbreak and kind of everybody got distracted, like other issues, like has it slowed down or are you doing less work there, where now maybe it pushes out some of the longer term opportunities?

I wouldn't say that, I think the best word is that it’s different now, a qualification process for a long, long time, it's a very face-to-face type of process that customers visit your plant. You visit the customer, obviously with travel restrictions that has been limited, but we deal with a very sophisticated customer groups. So we found other ways to continue to push this process along. I mean, I wouldn't say that we're at the exact speed that we were at prior to the pandemic, but it has not slowed much. Again because of the sophisticated customer base, they know that this market is coming back and they know prior to the pandemic, this is a sort of market that could not meet their demand. In other words, they couldn't build enough of the engines prior to the pandemic. So they know how important that system and they continue to push forward albeit in a different manner than we did before.

If there is still low hanging fruits in terms of like, some big products out there, a big volume products that could move the needle?

Yes. There's still a couple of big – once got there first to get qualified for sure.

Okay. And then just the last question, I thought Tim said distribution orders or demand picked up. I was wondering if that was just transportation related or did that tie into, I thought he said, there were some areas of aerospace that were getting better, just touch a little bit?

Just to be clear, when I said distribution, I was talking in the PEP business unit that segment. We've got a distribution business within our PEP segment. And I think Chris, that you're right at the comment, distribution is tied pretty significantly to transportation. So as the automakers returned to work, they saw a spike in demand.

Great. Thanks for all the info and the color, guys.

Ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Brad Edward for any closing remarks.

Thanks Chad. Thanks everyone for joining us today on our first quarter fiscal 2021 conference call. We look forward to speaking with all of you on our second quarter call. Thanks again, and have a great day.

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