Good morning, and welcome to the Carpenter Technology Corporation Second Quarter 2023 Conference Call. All participants will be in 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 of Investor Relations. Please go ahead..

Thank you, operator. Good morning, everyone, and welcome to the Carpenter Technology earnings conference call for the fiscal 2023 second quarter ended December 31, 2022. 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, 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 these 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, 2022, and Form 10-Q for the quarter ended September 30, 2022 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 referring to operating margins, that is based on adjusted operating income, excluding special items and sales, excluding surcharge. I will now turn the call over to Tony..

Thanks, Brad, and good morning to everyone on the call today. Let's begin on Slide 4 and a review of our safety performance. Through the second quarter of fiscal year 2023, our total case incident rate was 1.5. We did see improved performance in the second quarter, lowering the year-to-date rate.

The year-over-year rate increase is largely due to the increase of employees undertaking new tasks, either as new hires or transfers into new roles. To address this, we have enhanced and expanded training procedures for any employee new to a job or task with frequent monitoring and follow-up. Our ultimate goal continues to be a zero injury workplace.

We believe it is possible, and we will continue to work towards that goal. Now let's turn to Slide 5 and a review of the second quarter. Second quarter performance was driven by the strong demand environment in each of our end-use markets and the increase in productivity across our operating facilities.

We continue to see solid demand conditions in each of our end-use markets, with our backlog up 9% sequentially and 107% year-over-year. This marks the eighth consecutive quarter of backlog growth. Most notably, we see the aerospace and defense end-use market ramp accelerating.

As a result of the strong demand environment across our end-use markets, we continue to realize price gains. We announced another price increase on our transactional business in November and continue to raise prices through our regular contract negotiations.

In order to satisfy demand, we are focused on accelerating the productivity of our labor force across our facilities, most notably by safely onboarding new employees across all our production centers. And we are working closely with our customers to deliver more material sooner.

For the quarter, the SAO segment delivered operating income of $30.3 million, in line with our expectations. The improved performance was driven by the growing market demand in the aerospace and defense and medical end-use markets and continued operational improvements.

The PEP segment turned in another strong performance with $9.3 million in operating income for the recent quarter. In particular, we saw strong demand for titanium products for the medical end-use market. Finally, our liquidity remains healthy as we finished the quarter with $237 million in total liquidity.

Now let's move to Slide 6 and the end-use market update. All of our end-use markets were up sequentially, and with the exception of transportation, all were up year-over-year, reflecting the strong demand environment.

Our near-term and long-term outlook for each of our end-use markets remains positive, and record backlog levels provide strong evidence for this bullish market outlook. Our aerospace and defense end-use market, sales were up 9% sequentially and 50% year-over-year.

Global aerospace traffic continues its recovery, pushing the supply chain to continue to ramp production for new planes. As a result, we saw a strong demand in each of the commercial aerospace submarkets, in particular, the aerospace engine submarket.

The defense submarket is down sequentially and year-over-year, primarily driven by the uncertain government budget horizons and extended lead times. We see this as a short-term issue as there is continued interest in our advanced alloys for next-generation platforms. Excluding defense, aerospace sales were up 12% sequentially and 57% year-over-year.

More specifically, sales in the aerospace engine submarket were up 19% sequentially and up 78% year-over-year. As a result of the continued increases in demand, lead times across the industry have extended and our backlog continues to rise. Specifically, our aerospace and defense end-use market backlog is up 10% sequentially and 136% year-over-year.

Notably, our backlog value remains at record levels, reflecting price increases and customer urgency to secure material. In the medical end-use market, sales were up 26% sequentially and 55% year-over-year. The higher results reflect ongoing growth in elective surgeries.

Customers are increasing manufacturing activity and required stocking levels to meet demand. The overall outlook continues to be positive as medical procedures are expected to rise throughout calendar year 2023.

We are seeing evidence of this replenishment in the supply chain as our medical end-use market backlog is up 11% sequentially and 150% year-over-year. In the transportation end-use market, sales were up 15% sequentially and down 4% compared to last year.

Light-duty vehicle demand remains high even with the industry supply chain issues, limiting inventories. With strong demand and low inventories, build rates are expected to increase throughout calendar year 2023. In addition, we expect to see heavy-duty vehicle build rates rise in calendar year 2023, primarily driven by the increasing demand in China.

In the energy end-use market, sales were up 23% sequentially and up 41% compared to last year. In the oil and gas submarket, demand continues to outpace supply, driving growth and capital investment. In addition, we are seeing growing demand for our advanced premium alloy solutions for drilling and completions activities in harsh environments.

In the industrial and consumer end-use market, sales were up 15% sequentially and up 18% year-over-year. Sales growth was driven by demand for our alloys used in semiconductor fabrication and in our electronics submarket.

Specifically in the electronic submarket, we continue to see growing demand in new applications for materials from our hot strip mill in Reading. Now I'll turn it over to Tim for the financial summary..

Thanks, Tony. Good morning, everyone. I'll start on Slide 8, the income statement summary. Net sales in the second quarter were $579.1 million, and sales, excluding surcharge, totaled $420.8 million. Sales excluding surcharge increased 34% from the same period a year ago, on 17% higher volume. Sequentially, sales were up 12% on 12% higher volume.

Gross profit was $70 million in the current quarter compared to $13.1 million in the same quarter of last year and $54.8 million in the first quarter of fiscal year 2023. Gross profit is up substantially compared to the same quarter last year and up 28% sequentially.

The improvement in gross profit is primarily driven by higher sales and improving product mix and increased selling prices, partially offset by inflationary cost increases. SG&A expenses were $47.4 million in the second quarter, up about $3 million from the same period a year ago.

Note that the SG&A line includes corporate costs, which totaled $16.4 million in the recent second quarter. The reported corporate costs increased about $2 million from the same quarter last year and are largely in line sequentially.

As we look ahead to the balance of fiscal year 2023, we expect corporate cost to be $19 million to $20 million per quarter. Operating income was $22.6 million in the current quarter.

When excluding the impact of special items in the prior year quarter, adjusted operating loss was $29.8 million in the same quarter last year, and operating income was $8.3 million in our recent first quarter. Our effective tax rate for the second quarter was 19.5%.

As we said last quarter, as pretax levels increased throughout the fiscal year, we expect that the full year effective tax rate will be approximately 22% to 24%, but may continue to have variability on a quarterly basis. Earnings per share for the current quarter was $0.13 per share.

The results demonstrate our continued momentum supported by a strong demand environment. Now turning to Slide 9 and our SAO segment results. Net sales for the second quarter were $495.8 million or $346.2 million excluding surcharge. Compared to the same period last year, net sales, excluding surcharge, increased 38% on 14% higher volumes.

Sequentially, net sales excluding surcharge increased 13% on 11% higher volumes. The year-over-year improvement in net sales was driven by increased volume and higher prices as well as an improving product mix across our key end-use markets that Tony reviewed on the market slide. Moving to operating results.

SAO reported operating income of $30.3 million in our recent second quarter, a significant improvement versus our recent first quarter and prior year second quarter results. The improving operating income results reflect continued progress towards returning to our fiscal year 2019 run rates.

On a year-over-year basis, SAO adjusted operating income improved $49 million largely due to higher sales, coupled with an improving mix.

On a sequential basis, operating income improved $10.4 million, which is in line with the expectations we set last quarter and driven by increased volumes as we continue to ramp our operations to meet the strong demand that we are seeing across our end-use markets.

Looking ahead, our backlog grew sequentially again this quarter with steady order rates across all of our key end-use markets. As we have highlighted, we continue to see increased activity in the aerospace supply chain to meet anticipated increases in build rates by the OEMs.

Our teams remain focused on ensuring that we accelerate activity levels and production flow to meet the needs of our customers for the foreseeable future. Based on current expectations, we anticipate SAO will generate operating income in the range of $41 million to $45 million in the upcoming third quarter of fiscal year 2023.

Now turning to Slide 10 and our PEP segment results. Net sales in the second quarter of fiscal year 2023 were $106.7 million or $98 million excluding surcharge. Net sales, excluding surcharge, increased 17% from the same quarter last year and were up 12% sequentially.

The year-over-year growth in net sales reflects increased demand primarily in our Dynamet Titanium and additive businesses. In our Dynamet Titanium business, net sales increased in both the aerospace and defense and medical end-use markets from the same quarter a year ago.

We've also seen a significant improvement in year-over-year sales in our Additive business driven primarily by aerospace and defense market applications.

The sequential increase in net sales reflects increases in Dynamet Titanium sales to the medical end-use market as well as Additive sales to the aerospace and defense and industrial consumer end-use markets. In the current quarter, PEP reported operating income of $9.3 million.

This compares to adjusted operating income of $3.2 million in the same quarter a year ago, and operating income of $6.3 million in the first quarter of fiscal year 2023. The operating income improvement year-over-year and sequentially is primarily the result of increased net sales driven by strong market demand conditions.

As we look ahead, we remain confident that overall demand conditions will remain strong in the coming quarters. We currently anticipate that the PEP segment will deliver operating income in the range of $9.5 million to $11 million for the upcoming third quarter of fiscal year 2023. Now turning to Slide 11 and a review of free cash flow.

In the current quarter, we used $86 million of cash for operating activities. The cash used for operations in the current quarter was driven by increasing inventory. During the quarter, we increased inventory by $106 million.

The increased inventory is a result of ramping up production activities to satisfy the growing demand, namely the targeted shipments for the second half of fiscal year 2023. We anticipate that as we move through the balance of fiscal year 2023, we will reduce inventories from the current levels.

The reduction will be driven by increased shipments and a more balanced flow of materials across the operations. In the second quarter of fiscal year 2023, we spent $18 million on capital expenditures.

Given the timing of certain projects and ongoing delays due to extended lead times, we expect fiscal year 2023 capital expenditures to be in the range of $85 million to $90 million, which is down slightly from our previous guidance of $100 million.

Lastly, as I've highlighted before, we continue to fund a constant dividend to our shareholders, which we consider as part of free cash flow and an important part of our overall shareholder return. With those details in mind, we used $114 million of free cash flow in the second quarter of fiscal year 2023.

Our liquidity remains healthy, and we ended the current quarter with total liquidity of $237 million, including $20 million of cash and $217 million of available borrowings under our credit facility. As I mentioned, we expect to reduce inventory in the second half of the fiscal year.

The inventory reduction, combined with our expectations for continued earnings momentum, are anticipated to drive free cash flow generation in the upcoming second half of our fiscal year 2023. With that, I'll turn the call back to Tony..

Thanks, Tim. Now to recap our second quarter of fiscal year 2023. We are operating in a strong demand environment with positive near-term and long-term outlooks in each of our end-use markets. Notably, the aerospace submarkets continue to accelerate their recovery.

As a result, our backlog continues to grow, and we expect it to remain strong for the foreseeable future. We will continue to offset inflationary pressures through our raw material surcharge mechanism and our ability to increase prices on both our contractual and transactional business.

As I noted earlier, we are focused on increasing the productivity of our labor force across the facility by safely onboarding a significant influx of new employees across all of our production centers. By increasing volumes, improving mix, increasing prices and improving productivity, we will continue to see margin expansion.

As a result, we will continue to maintain a healthy liquidity position. We did build inventory at certain stages of the production flow in the first half of the fiscal year to make sure we have the necessary resources to serve our customers.

As Tim mentioned earlier, we expect the inventory balance will come down as we move through the second half of the fiscal year. And looking ahead, we are positioned to achieve our goal of delivering operating income at the fiscal year 2019 run rate range in the fourth quarter of fiscal year 2023.

Let's turn to the next slide and take a closer look at our full fiscal year 2023 outlook. On the last two earnings calls, we talked about our goal of achieving the fiscal year 2019 operating income run rate by the fourth quarter of this fiscal year. Let me provide more insight into how we see the next two quarters playing out.

Demand remains strong across all of our end-use markets as evidenced by growing backlogs and extending lead times. We participate at the high end of attractive markets, which are driven by positive macro trends. Therefore, in terms of demand, we see minimal risk in our fiscal year 2023 projections.

Specifically, over the next two quarters, we anticipate sales excluding surcharge to grow at approximately 12% to 13% per quarter, driven by increased productivity through production rate increases.

The most critical variable in our continued effort to increase production rates is the pace at which we can safely train and develop the workforce, many of whom are new to their role in the last 12 months. With this in mind, we have provided operating income projection ranges for the third and fourth quarters of fiscal year 2023.

Earlier, Tim communicated the SAO and PEP segment third quarter operating income outlook. Those combined with estimated corporate costs, results in a total company projected operating income range of $30.5 million to $37 million for the third quarter, a strong sequential increase.

For the fourth quarter, taking into account the variables I just noted, we project total company operating income to be in the range of $54 million to $60 million, a relatively small window in total dollars. It is worth noting that this represents at least 140% operating income increase over the current second quarter results.

And not to get too far ahead, but we expect the first quarter of fiscal year 2024 to have another meaningful increase in operating income compared to the fourth quarter range just given. We will give you more color on that over the coming quarters.

It is an exciting time for Carpenter Technology as we are not only poised to return to pre-pandemic earning levels in the near term, but also have a path to significantly increase earnings over the coming years. Thank you for your time. And now I will turn it over to the operator to take your questions..

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

Thanks, guys. I just want to make sure I have this right, first on the guidance comments.

Did you say 12% to 13% ex surcharge sales growth in Q3 and Q4? Did I hear that right?.

That's correct. Yes, Gautam. Good morning. .

Good morning.

Does that imply a sequential decline in sales ex surcharge?.

No. You take the second quarter sales. Third quarter will be 12% to 13% higher and then take another 12% to 13% on that..

You meant sequentially. I apologize. Okay. I just want to make sure wasn't year-over-year. The commentary on Q4, now the range of $54 million to $60 million, previously, it was around $60 million.

Is there anything specific that explains the slightly lower midpoint or low end?.

Yeah. As I said in my comments ---.

Corporate cost..

No, it's not corporate cost. It's not demand. It's really our workforce and training them safely and effectively to produce those rates to run at the rates. That's really the gating factor right now. And I've heard that from many other companies in the industry as well.

If you remember, our workforce decreased significantly during COVID and now we're building that back up. So it takes some time to get them trained. Now I'm a quarter closer. I just want to give a little bit of range. If we hit what we say we're going to hit, we'll be closer to the 60% in terms of the training..

Got it.

And then the Q1 comment, did you mean to suggest it will be higher than the $54 million to $60 million, so way better than normal seasonality?.

Yes, because I think -- keep in mind, inflection where our shareholders or people that might -- that needs a little bit more runway as far as what they see us doing. So I'm always trying to be a couple of quarters out there.

Now I might not give all the color that someone like yourself might like, but at least trying to give some directional guidance, assuming there's always your normal risk factors. But assuming that it goes the way we see it. But yes, we would see the first quarter then take another step up from that 50-40-60..

And then I was just curious on the cash use in the first half. The cash balances quite low at ending the quarter and then the leverage is a bit up.

What do you think will happen with respect to free cash flow in the second half? Do you guys have an updated forecast for that?.

Well, I'll tell you this, Tim mentioned it on the call. I think I mentioned it as well that we intend to take inventory down in the second half. And we're not going to do that randomly. I mean the demand is going to be higher, so it's going to pull that inventory.

And then the earnings are going to be significantly higher as well, right? I mean that 54% to 60%. If you hit that, that's -- as I said, it's 140% higher than what we just did. So your free cash flow will follow those two items. I think you'll have pretty healthy free cash flow, obviously, compared to the first half..

Okay. And just stepping back on backlog, you mentioned a 9% increase.

Could you just talk a little bit about engines versus fasteners versus other structural components in aero? And then maybe just give some flavor for where you're seeing the order strength maybe sustain and improve, and if you're seeing any areas that are a little bit softer?.

Well, right now, I'm not seeing any areas that are soft. I mean all of our customers are asking for more sooner. I mean to answer your question specifically, year-over-year, engines backlog is up 180%-plus, faster than 160%. If you look sequentially, it's up 8%, 9%. So big increases in all the backlog.

And you're getting to a point where the backlog isn't as meaningful. In other words, we're over 52 weeks. And there's plenty of demand out there. So we're at -- I think we're at 2x the backlog we had even back in FY '19 when you had the type of demand you had back then..

Thanks, Tony. .

Thank you, Gautam. .

[Operator Instructions] Our next question comes from Joshua Sullivan from the Benchmark Company. Please go ahead..

Good morning.

As we think of that labor influx now to support that step up into the fourth quarter, will you need additional labor inputs to get to the Q1 numbers and beyond? Or is there a leveling off at some point in headcount?.

Yeah, it's a good question. So -- and I'm glad -- I appreciate you asking it. Let me give a couple of bullets around that. I just -- that might be helpful for you. I mean, certainly, as I just mentioned to Gautam, like most companies during the COVID pandemic, we allowed our maintenance production workforce to decrease significantly through attrition.

We had a higher rate of retirements during that period of time. Now over the last year, we've had an accelerated pace in bringing back employees across all of our locations. So of course, that gives you a less experienced workforce. And I jotted down a little stat here.

If you look at some of our critical work centers at our largest facility, you could have anywhere range from 30% to 35% of employees at that workstation have less than a year. So you know your way around a manufacturing site. That is a significant amount to be able to produce it through rates you want to produce that.

Now certainly, there's a tight labor market. I believe our -- we're making very good progress. We have very fulfilling jobs. We have competitive wages, attractive benefit plans. So we're right there. I would say we're probably 85% to 90% as far as the work staff -- workforce that we need.

There's some more that we want to hire in a couple of critical work centers. Now to give you some comfort, that's not a couple of thousand, that's maybe 200 or 300 more on roughly 2,500 person our workforce in SAO..

Got it. And then any commentary out of the aerospace supply chain, they can't get enough engine-related materials.

But from Carpenter's perspective, what takes aerospace sales incrementally higher from here? Is it increased capacity on your end? Or is it increased pull from customers just given where you guys supply chain?.

Yeah. Three things, not in any particular order. One, yeah, we increase our productivity. And remember, part of that increased productivity is our Athens facility. So we have that. So we know demand is going to go higher. We have organic productivity at our existing plants, and then we have Athens.

We have mixed management, as you see some of these markets like aerospace and medical get stronger and stronger. You'll see us move more towards those markets and cut off the tail, if you will, even more than we have in the past. And then the third big driver is price. We've been able to increase price significantly.

And even if you do some math, quick math and SAO with -- take the sales and we give you shipments by pound, do the math, you're probably a pound higher than you were in FY '19, which was one of our best financial years ever.

So pricing is a big item that a lot of people tend to forget about because they all want to know how are you going to get more productivity, where is the capacity, the price and the mix management is a big factor in that..

Yeah.

And then just on the defense impact you mentioned, can you just highlight some of the dynamics there? What types of alloys or defense products is that impacting? And then how might we see that rebound?.

Sometimes, it's such a small piece, you sometimes wonder whether that's even really relevant in the whole scheme of our earnings release. I don't see any issues there. You know the areas that we that we provide in defense were more on the munition side than armament, but we have a variety of alloys that we sell into defense.

And quite frankly, we see defense as a growth area for us going forward. But because of the dynamics, you'll see some variability up and down every quarter. It was only a couple of quarters ago, I think that it was a big increase in defense, and I said not to get too excited about that, that's just the normal variability inside the defense submarket..

Yeah. Thank you for the time. .

Thank you. .

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

Thanks, Jason. I appreciate it. Thanks, everyone, for joining us today for our fiscal 2023 second quarter conference call. We appreciate your time and support and look forward to connecting with all of you in the near future. Thanks again, and have a great rest of your day..

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