Carpenter Technology Corporation

Good morning and welcome to the Carpenter Technology Corporation first quarter fiscal 2021 conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. 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 30th, 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 Tain, President and Chief Executive Officer, and Tim Wayne, 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 Technologies' most recent FCC 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 four. Our total case incident rate, or TCIR, was 0.4 in the first quarter. This marked our lowest quarterly PCIR 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 operate in, while at the same time staying focused on serving our customers. Now let's turn to slide five and review the first quarter. Our first quarter operating performance was in line with our previous guidance as demand headwinds across our in-use markets continue to be the driving factor. Given the current environment, the 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 Omega 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 have further strengthened our capabilities in critical emerging technologies, most recently through the launch of our carpenter electrification brand. Electrification is a rapidly growing area of focus across our in-use market. and we believe our material solutions can help customers drive enhanced performance for their 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 six in 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 in-use market. Starting with the aerospace and defense in-use market, and specifically the aerospace sub-market, the supply chain continued to adjust to revised forward build rates and a lowered demand environment. Most supply chains continued 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 continued to report refusals of obligations throughout the supply chain, and several customers, especially in Europe, had longer-than-normal extended shutdowns. We continued to work closely with all of our customers and finalized commercial discussions with many regarding forward sales arrangements. Though at depressed levels, we continued to secure and support areas of real demand. Cancellation and deferral requests, while not altogether behind us, did decline in the quarter. Direct bookings were relatively flat, though 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 these stocking requirements. While we are seeing 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, though 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 submarket, 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 in-use market. From a macro perspective, as it relates to trends in elective procedures, hospitals reported a gradual recovery of procedures beginning in fiscal Q1, with 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 the stocking 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, confidence is returning to the supply chain, and we believe we can benefit given the unique value our high-temperature solutions deliver. In the heavy-duty truck sub-market, we began to see signs of recovery off historical low levels due in part to cyclical timing, but also increased freight demand. Now moving to the energy and use market. where conditions in North America remain challenged, and drilling activity is at severely depressed levels. International markets have held up better due to longer project cycle lead times, but 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, and a potential uptick remains in the early stages. Lastly, for the industrial and consumer-induced 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 eight, 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 have 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 include 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 include 7.9 million 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 a 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 a 1.2 million discrete tax charge associated with certain stock-based compensation awards investing in the quarter. Earnings per share for the quarter was a loss of 98 cents per share. When excluding the impacts of special items, adjusted earnings per share was a loss of 58 cents per share. Now turning to slide nine 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 last year, sales excluding surcharge decreased 35% on 28% lower volume. 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. SEO reported an operating loss of 18.6 million for the current quarter. The same quarter a year ago, SEO's operating income was 81 million, and in the fourth quarter of fiscal year 2020, SEO generated 5.3 million of operating income. The year-over-year reduction in operating income primarily reflects the impacts of lower volume, as well as the negative income statement impacts of reducing inventory. To note, during the quarter, SAO reduced inventory by approximately 73 million. Sequentially, the lower operating income result is principally the result of lower volume, as well as the impact of an unfavorable product mix due to the pronounced decline in airspace 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 costs 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 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 to 23 million in the second quarter of fiscal year 2021. This estimate includes 3 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 is driven by the impacts of lower demand as a result of COVID-19, particularly in aerospace and defense, medical and distribution. Additionally, sales in the energy and use market declined as a result of our exit of the Omega 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 saw a sequential increase in sales off a relatively low base. 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 the savings realized from the actions we initiated over the last several quarters, both in our additive business unit and the recent divestiture of our Omega West oil and gas business. The approach to reducing costs in additives has been balanced in that we recognize 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 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 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 plan for fiscal year 2021 is 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 will 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 Mega West oil and gas business. We are pleased that we could complete this transaction and realized 18 million of proceeds in our current quarter. With those highlights in mind, we generated 63 million of free cash flow in 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 used 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 is treated as a special item, net of tax, when calculating adjusted EPS. Our focus on 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 will 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 liquidity, and working closely with our customers. While our near-term focus is centered on the execution of those priorities, we cannot turn a blind eye to our future and the future needs of our customers. During its long history, corporate 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 are 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 robots, 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. Improved system design and new technologies 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 permeability, and low-loss soft magnetic alloys are delivering performance benefits, 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 OEMs bring new electrification solutions to the world. With the technology and market demand as a backdrop, we remain excited about the completion of a 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 and 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 have chosen not to simply sit back and wait for market conditions to improve, rather we continue to actively manage our organization and align our cost structure and business activities with evolving in-use 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 improvement via the carpenter operating model, executing on targeted portfolio actions, including idling and divesting underperforming businesses, as well as reducing costs through position eliminations, temporary furloughs, and hiring freezes, among many other actions. With the bulk of our growth investments largely completed, we are also able to significantly reduce capital expenditures beginning in fiscal year 2021. These actions have 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 enable 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 Carpenter 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.

To ask a question, you may press star then one on your telephone keypad. If you're using a speakerphone, please pick up your handset before pressing the keys.

To withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. And the first question will come from Gotham Conner with Cowan. Please go ahead. Hi, good morning, guys. Thanks for the detail.

Good morning, Gotham. I wanted to just maybe ask you to expand on your comments about kind of the various levels of channel inventory. You know, we have some customers with a year's worth and some that are restocking. Is there any broad trend you can characterize? Maybe if you could talk about, you know, engine-oriented applications versus fasteners versus other airframes. or if there's anything you can expand upon. There's really no more additional color there. That cuts across all of our customers, so I wouldn't classify it as the engine customers are the ones that have greater inventory or not. We see variations across whether it's engines, fasteners, structural our distribution business in aerospace. So really no difference there gotten.

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, you know, demand recover.

What grounds that view? I'm just curious, like, do you have order visibility? Do you have, you know, 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. In fact, we just reaffirmed that internally going through it, you know, customer by customer, market by market. So I don't think you're going to see a 50% increase in the second half, Colin. 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. keeping in mind that first and second quarter have been obviously extremely low. So, yes, we're fairly confident that we'll see an uptick 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 X surcharge sales will shake out once we get through destocking as 30% or 40% below what you guys did in fiscal 19, you know, 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, you know, Is that where we should think things level out? Kind of 60, 70% of where they were pre-COVID because the production rates are down by that level?

Or is there some sort of offset to that where we share or otherwise, or downside to that because of?

Really? Yeah, really.

Yeah, got them. 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, you're in that team type of recovery that I think you'll see. And I think it's going to be a gradual improvement year. Got it.

Like 10 to 15% above where we are now, thereabouts.

Yeah, I think that's reasonable. I think that's reasonable, yeah. Okay. And just last one for me, any changes as you talked about, you know, coming to better, more mutually beneficial kind of agreements with customers over the mid and long term? I've just been curious, what types of things is Carpenter advocating for? Is it kind of minimum quantity guarantees? Is it better pricing? What are the types of things that you guys are advocating for to kind of – what would you consider better terms? Yeah, it's a good question. We have great relationships with our customers, and it really hasn't been – where 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 market is going to come back. There's 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 again, It is a very, it's a mutual respect type of relationship. And what we're looking for and what they're, in many cases, very happy to do is 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. 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. Hello, Josh.

On the refuel of service that you mentioned that the aerospace customers for Q3 prepared much there. What is the tempo of those here in early Q4? Is it the same pace as Q3 or those instances you know, either decelerated or accelerated here.

Well, I made that comment, you know, that's across, I'm saying that across all those supply chains, 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 slowdown, everyone's trying to conserve cash and many people are trying not to take shipments. So that's happening across the entire supply chain, across every level. That's pretty well known. From our standpoint, it's much like the answer I just gave Gotham, is 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. Got it. And then just on the medical exposure, you know, how do you think that the restocking takes place? You know, is there going to be a snapback as those elective surgeries come back? You know, we might see COVID resurge here. Just what are you thinking about the restocking on the medical side in the timing of it?

I think that, you know, Josh, that's a really good question. In my remarks, you know, 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 are decreasing their inventories. Everybody's looking to conserve cash. What we're getting prepared for is that I think you could see a steeper recovery than in the second half as opposed to what you would normally see because I just don't think there's a one-for-one right now. I think people are still trying to protect their inventories, 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. So a long way of answering your question is to say, yes, I think that the spike that you'd see in shipments or demand, let's say, for medical could be a little steeper than maybe other markets.

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

Well, the three big components are 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 drawdown that we're having is not an approach that says take 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 for future dates, knowing that, you know, I was never going to shut down the front end of my process that had 50-week lead times. So our inventory got a little higher than what we would have liked 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 to become more balanced. Inventory, in many cases, is a detractor 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 inventories for the next four, five, six quarters. There will be a time where we're balanced. I think the important thing is, Josh, is 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 we see a demand pick up over the next several quarters.

That's very helpful. And then just one last one. You talked about your push into the electric world. Can you talk a little bit about your – You know, your special allies there, you know, how do those compare to the current market offering? Is there any way to quantify some of the, you know, special attributes, weight, power, or some metric why you think Carpenter is going to be, you know, 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, you know, in this, what we call soft magnetics and running an electric motor, you know, the real key there is that the material that you're using, that soft magnetic material, is 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 dictate the magnetic response, or what I said in my prepared comments, the induction. So the higher the induction material, 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, Hyperco, 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 staff 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 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 ten years. So I really appreciate the question and allow us to talk about something that can really be an earnings accelerator for corporate technology over the next year.

Thanks for the comment. Once again, as a reminder, if you would like to ask a question, please press star then one. The next question will come from Phil Gibbs with KeyBank Capital Markets. Please go ahead.

Hey, good morning, Tony and team. Yeah, good morning. Tony, can you give us some color on your backlog, either the 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 engines specifically, what was the either year-over-year or sequential decline in engine revenues?

If you look at engine, 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, you're comparing to periods a year ago that were at the high point of the last five to 10 years, you were at the high point. So they're coming off the tops, but you're 50% down.

So you're saying year over year down 50?

Yes, on Arrow Engine. Okay.

Yes. 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. 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 lost absorption 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, you know, intrinsic profit would have been. Would it have been closer to break even if you hadn't been taking out inventory and losing absorption?

Yeah, I'll let Tim take that one on him being involved.

Yeah, 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 that don't go into inventory. Then you've also got the variable costs 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 a $3.5 million hit from COVID costs.

The COVID costs we said were about 7.3. We said including that 7.3 is a $3 million bankruptcy impact. So direct costs about four. So just to clarify on that.

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 reported.

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

Yeah, 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, you know, rentals of equipment and extra PPE for the people in the facilities. There's some aspect of, you know, as people suspect they have been exposed to COVID-9 or paying them to stay home. And then just kind of other operating supplies, you know, for just general protection in the current environment.

Thanks very much.

And the next question will come from Chris Olin with Tier 4 Research. Please go ahead.

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

Good morning, Craig.

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 a tail end of the magnetic Q&A session, and I just wanted to make sure I understood how I should think about the timeline. I guess maybe you've given numbers I've just forgotten, but how do I think about... You were saying demand could be five to ten times greater, and you mentioned earlier the 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 because I was wondering if there was any wiggle room in terms of the cap ads and the timeline for the hospital.

Yeah, just to be clear on that, I said the current available market to us could be you know, three to four times higher over the next five to 10 years. So not five to 10 times higher, three to four times higher. Yeah. Okay. So that's still a big, still a big number. And I think Chris, you followed us for a long time. You're aware that we've been in this market for, for quite some time on the APU side with aerospace. And it's just a way for us to really broaden that, you know, I mean, we're moving more and more towards electrification and, So this just takes proprietary products and now process and increased equipment into other markets like transportation, defense, and 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 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 stories. 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 at a very small scale. They're doing the testing of 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 is not only do we have the expertise, we have a proprietary product, and we now within the next three to 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 are closer and closer to them in the supply chain, whether that be in the building of stacks, 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 hit the bottom line in the near term. It's not a decade away.

Okay. That makes sense. One of the issues I used to follow pretty closely was 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 by 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. You know, a qualification process for a long, long time is a very face-to-face type of process. The customer visits your plant, you visit the customer. Obviously, with the travel restrictions, that has been limited, but we deal with a very sophisticated customer group, 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 sold-out market that could not meet their demand. In other words, they couldn't build enough engines prior to the pandemic. So they know how important that facility is and they continue to push forward, albeit in a different manner than they did before.

Is there still low-hanging fruit in terms of, like, you know, some big products out there, big volume products that could move the needle?

Yeah, there's still a couple big – was out there for us 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 you said you, there was some areas of aerospace that were getting better. I'm just curious what drove that.

Yeah. Just to be clear, when I said distribution, I was talking in a, in a pet business unit, my pet 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 automakers return to work, they saw a spike in demand.

Great. Thanks for all the input on the call, Chris.

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

Thanks, everyone, for joining us today on our first quarter fiscal 21 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.