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 the COVID-19 pandemic.

In the first quarter, we completed the divestiture of our Amega West oil and gas business and took additional restructuring actions in our additive business unit to streamline operations and reduce costs.

At the same time, we are pushing forward with our long-term growth initiatives and balancing our actions to ensure that we emerge in an even stronger market position with our customers. This includes our Athens facility, which remains a key long-term growth driver and differentiator for Carpenter Technology.

We continue to collaborate with customers and make progress on achieving key additional qualifications for the facility. In addition, we further strengthen our capabilities in critical emerging technologies. Most recently, there's a launch of our Carpenter Electrification brand.

Electrification is a rapidly growing area of focus across our end-use markets. And we believe our material solutions can help customers drive enhanced performance for the products. Our new hot strip mill installation is nearing completion, which will enable us to further excel in our capabilities in this emerging area.

Now let's move to Slide number 6 and the end-use market update. Let me spend a little more time than usual on this slide as I anticipate, most of the questions will be focused on market dynamics, especially in the Aerospace and Defense end-use market.

Starting with the Aerospace and Defense end-use market, and specifically the aerospace sub-market, the supply chain continued to adjust to revise forward build rates and a lowered demand environment.

Most supply chains continue to be over inventory and OEMs continued the process of adjusting inventory levels across the supply chain during the quarter. Individual customers reported ongoing destocking at various rates.

Many customers continue to report refusals of obligations throughout the supply chain and several customers, especially in Europe had longer than normal extended shutdowns. We continue to closely with all of our customers and finalized commercial discussions with many, regarding forward sales arrangements.

Lower depressed levels we continued to secure and support areas of real demand. Cancellation and deferral request while not altogether behind us did decline in the quarter. Direct bookings were relatively flat, no stock shipment activity declined as customers had lowered consumption requirements versus stock contracts.

In our fiscal second quarter, we expect customers to continue to work through destocking requirements. While we have seen an uptick of demand activity in some limited areas, most customers continue to report significant amounts of inventory.

At the extreme, some customers report over 12 months of inventory at the current shipment levels for certain parts. On the other end, some customers are beginning to discuss restocking at very limited levels.

During our second quarter, we are continuing to support near-term customer needs and are also in negotiation with key customers, developing mutually beneficial outcomes in both the mid and long-term. As credit has become an increasing concern with some of our customer base.

We are also closely monitoring and adjusting to customer financial situations as necessary. Concerning our defense sub-market, we continue to see steady activity standing in contrast to commercial aerospace.

Many of our customers involved in commercial aerospace are also involved in defense and some customer locations report defense work as the main activity that is currently sustaining their operations. Some of the defense programs we support are seeing increased activity and we are working to support these accordingly.

We continue to be involved in new platform design and prototyping and remain excited about our long-term growth. Let's turn to our Medical end-use market. From a macro perspective, as it relates to trends in elective procedures, hospitals reported a gradual recovery of procedures beginning of fiscal Q1 if recovery expected to continue.

Medical device companies acknowledged this gradual return of elective surgeries during fiscal Q1, but are continuing to manage inventory levels downwards and only reordering necessary materials to replace critical needs.

We expect destocking efforts to level off within our fiscal Q2 at both OEMs and distributors that support the medical device market. In the Transportation end-use market, sales increased 42% sequentially, but we're down on a year-over-year basis. Global light-duty vehicle production rebounded across most global markets.

In North America, we believe the light vehicle market is currently on track to recover and come close to reaching pre-pandemic levels in calendar year 2021. Overall, competencies returning to the supply chain and we believe we can benefit given the unique value, our high temperature solutions deliver.

In the heavy-duty trucks sub-market, we began to see signs of recovery of historical low levels due in part to cyclical timing, but also increased freight demand. Now moving to the Energy end-use market, where conditions in North America remain challenged and drilling activity is at severely depressed levels.

International market has held up better due to longer project cycle lead time or current activity levels are low. In the power generation sub-market within Energy. We are seeing some signs of increased activity related to a delayed maintenance cycle, but a potential uptick remains in the early stages.

Lastly, for the Industrial and Consumer end-use market, sales were up both year-over-year and sequentially. Industrial sales were driven by continued strong demand for our semiconductor and control applications. Now I'll turn it over to Tim for the financial review..

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 services to execute enhanced cleaning protocols, isolation pay for employees potentially exposed to COVID-19 and additional personal protective equipment and other operating supplies and costs necessary to maintain the operations while keeping the employees safe against possible exposure.

The COVID-19 costs in the current quarter also include $3.1 million of costs associated with a customer bankruptcy, resulting from the COVID-19 pandemic. The operating loss was $48.8 million in the quarter.

When excluding the impact of the special items, adjusted operating loss was $30.9 million, compared to operating income of $59.8 million in the prior year period and an adjusted operating loss of $10.7 million in the fourth quarter of fiscal year 2020.

Again, the current quarter’s results reflect the impact of significantly lower volume combined with the targeted inventory reduction. Our effective tax rate for the first quarter was 28.6%.

The income tax benefit was below our full year tax rate guidance as a result of the discrete tax impact of the special items, as well as $1.2 million discrete tax charge associated with certain stock-based compensation awards vesting in the quarter.

Earnings per share for the quarter was a loss of $0.98 per share, when excluding the impacts of special items, adjusted earnings per share was a loss of $0.58 per share. Now turning to Slide 9 and our SAO segment results. Net sales for the quarter were $300.7 million, or $254.8 million excluding surcharge.

Compared to the first quarter of last year, sales excluding surcharge decreased 35% on 28% lower volumes. Sequentially, sales excluding surcharge decreased 17% on 6% lower volume. The results reflect ongoing demand headwinds in Aerospace and Defense as the supply chain continues to deal with the near-term reductions in OEM build rates.

This is partially offset by stronger shipments and transportation as North American production returned from COVID-19 related shutdowns and by higher demand in certain industrial applications, SAO reported an operating loss of $18.6 million for the current quarter.

The same quarter a year ago, SAO’s operating income was $81 million and in the fourth quarter of fiscal year 2020, SAO generated $5.3 million of operating income. A year-over-year reduction in operating income primarily reflects the impacts of lower volume, as well as the negative income statement impact of reducing inventory.

To note, during the quarter SAO reduced inventory by approximately $73 million, sequentially, the lower operating income results is principally the result of lower volume as well as the impact of an unfavorable product mix due to the pronounced decline in Aerospace and Defense.

In addition, the current quarter’s results reflect approximately $7.3 million of direct incremental costs associated with our efforts to protect our facilities and employees against COVID-19. And as I mentioned earlier, also includes $3.1 million of cost associated with a customer bankruptcy directly resulting from COVID-19.

Looking ahead, we expect demand conditions across most end-use markets will remain challenged in our upcoming second quarter of fiscal year 2021. As we have stated before, we anticipate that the demand environment across our key end-use markets will stabilize and begin to recover as we enter the second half of our fiscal year of 2021.

In response to current market conditions, we continue our focus on managing costs and further enhancing our liquidity position via working capital management. Based on current expectations, we expect SAO to generate an operating loss of approximately $18 million to $23 million in the second quarter of fiscal year 2021.

This estimate includes $3 million to $4 million of COVID-19 related costs in the quarter. Now turning to Slide 10 and our PEP segment results. Net sales, excluding surcharge were $61.2 million, which were down 43% from the same quarter a year ago and down 20% sequentially.

The year-over-year decline in sales was driven by the impacts of lower demand as a result of COVID-19, particularly in Aerospace and Defense, Medical and Distribution. Additionally sales and the energy end-use market declined as a result of our exit of the Amega West oil and gas business.

The sequential decline in sales follows the themes covered in the market summary. Ongoing near-term demand pressures in Aerospace and Defense and Medical are due primarily to the impacts of the global pandemic and its impact on aircraft OEM build rates and medical elective procedures.

The bright spot was in our distribution business, where we fell a sequential increase in sales off the relatively low bates.

In the current quarter PEP reported an operating loss of $3.6 million, this compares to an operating loss of $8.4 million in the fourth quarter of fiscal year 2020, and an operating loss of $2 million in the same quarter last year.

The sequential operating results reflect the unfavorable impacts of lower volume driven primarily by COVID, offset by some savings realized from the actions we initiated over the last several quarters, both in our additive business unit and the recent divestiture of our Amega West oil and gas business.

The approach to reducing costs in additives has been bounced and that we recognized the importance of being innovative in this business and remain excited about its long-term future prospects.

With that approach in mind, we took action to rationalize our footprint and infrastructure, and we have identified areas where we can reduce costs without affecting our ability to capitalize on the anticipated long-term growth opportunities.

As we look ahead, we currently anticipate PEP will generate an operating loss of $3 million to $5 million in our upcoming second quarter. Now turning to Slide 11 and a review of free cash flow. In the current quarter we generated $88 million of cash from operating activities.

This cash generation was driven by improvements in working capital, primarily inventory. Within the quarter, we decreased inventory by $85 million with a bulk of the inventory reduction coming from SAO.

This reduction is substantial and the result of considerable effort throughout the organization to accelerate targeted inventory reduction programs across our facilities. It's worth noting that we also reduced inventory by $117 million in the fourth quarter of fiscal year 2020.

That's a reduction of over $200 million of inventory in the last two quarters. We remain in constant communication with our key customers to ensure that we maintain the appropriate inventory and lead times are aligned as demand patterns change. In the first quarter, we've spent $33 million on capital expenditures.

We remain on track to spend about $120 million in capital expenditures for fiscal year 2021 as planned. As a reminder, within the $120 million planned for fiscal year 2021, it’s the completion of the multi-year $100 million hot strip mill project to support growing demand for our soft magnetics materials.

Tony will speak to the importance that this new hot strip mill, we’ll have to further enhance our leading position in the emerging area of electrification. We are also nearing the completion of a large scale ERP system implementation that is expected to be operational in the second half of this fiscal year.

In addition, as I mentioned previously, we completed the divestiture of our Amega West oil and gas business. We are pleased that we could complete this transaction and realize $18 million of proceeds in our current quarter. With those highlights in mind, we generated $63 million of free cash flow on the quarter.

From a liquidity perspective, we ended the current quarter with a total liquidity of $613 million, including $219 million of cash and $394 million of available borrowings under our credit facility.

The increased liquidity reflects the cash flow generation in the quarter, as well as the debt refinancing we completed in the quarter, in which we issued $400 million of notes and use the proceeds to repay the $250 million of notes that were due to mature in July of 2021.

For reference the net incremental cost of extinguishing the notes of $8.2 million is included in our reported interest expense for the quarter and it's treated as a special item net of tax, when calculating adjusted EPS.

Our focus on the liquidity is essential in the near-term, as we work our way through the temporary market disruptions brought on by COVID-19 in our end-use markets.

Our thoughtful approach to capital allocation over the years, as well as the actions we have taken since the onset of the pandemic have been critical and will enable us to exit this latest challenge even stronger than we entered. With that, I'll turn the call back over to Tony..

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 cars, aircraft, and other mobility applications, size and weight are always issues that must be considered for overall performance.

Vehicle designers are increasingly turning to more powerful and efficient motors, that must also be small and light. Improve system designs and new technologies that will deliver the performance improvements needed for future applications. New designs are using advanced state of the art materials to achieve optimal performance.

Our high induction, high formability and low loss soft magnetic alloys are delivering performance benefit, miniaturization and product development flexibility. As product manufacturers push the boundaries of performance for electrification, they need stronger technology partners.

Applications and testing support are increasingly important, as companies work to optimize their product designs. They also need a reliable and streamlined supply chain and partners that can scale with them from prototype to production.

With our high performance soft magnetic alloy portfolio, technical expertise and advanced production capabilities, Carpenter Electrification is uniquely positioned to help electronics, motor and vehicle OEM, bring new electrification solutions to the world.

With the technology and market demand that had backdrop, we remain excited about the completion of the hot strip mill installation on our Reading campus. This project once completed later this fiscal year will provide us with significant capability and critical capacity to service this growing opportunity.

Now let's turn to the next slide with my closing comments. Our first quarter performance was as anticipated, given volume and cost headwinds related to COVID-19, as well as our focus on driving and preserving liquidity in the near-term.

Looking ahead, we expect market conditions will remain largely challenging, but do anticipate some recovery in the second half of fiscal year 2021. We've chosen not to simply sit back and wait for market conditions to improve.

Better we continue to actively manage our organization and align our cost structure and business activities with evolving in used market conditions. We've taken significant action since the start of the pandemic to reduce costs and generate cash flow.

These actions include accelerating working capital improvements via the Carpenter operating model, executing our targeted portfolio actions, including idling and divesting underperforming businesses, as well as reducing cost, we position eliminations, temporary furlough and hiring freezes among many other actions.

With a bulk of our growth investments, largely completed, we are also able to significantly reduce capital expenditures beginning of fiscal year 2021. These actions has been critical to maintain our healthy balance sheet and provide ample liquidity to weather the near-term challenges created by the pandemic.

Despite the challenges related to COVID-19, today we remain an established supply chain partner and often one of only a few providers, especially solutions that enabled mission critical performance. We are a leader in our industry today and are committed to remaining a leader for decades to come.

In the face of these unprecedented times, we reaffirm that we expect to generate positive free cash flow and positive adjusted EBITDA in fiscal year 2021. We have taken and will continue to take the necessary steps to position corporate technology to be an even stronger company on the other side of this pandemic.

Thank you for your interest and I'll turn it back to the operator to field your questions..

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..