Good morning, and welcome to the Carpenter Technology's Second Quarter Fiscal 2020 Earnings Conference Call. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Brad Edwards, Investor Relations. Please go ahead.

Thank you, Operator. Good morning, everyone, and welcome to the Carpenter Technology Earnings Conference call for the fiscal second quarter ended December 31, 2019. 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, 2019, Form 10-Q for the quarter ended September 30, 2019 and the exhibits attached to those filings. Please also note that in the following discussion, unless otherwise noted, when management discuss the 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 on the call today. Let's begin on Slide 4 and a review of our safety performance. Our total case incident rate, or TCIR, stands at 1.3 through the second quarter of fiscal year 2020. Our employees are the face of our safety program. They are the most knowledgeable about the workplace and know-how to make it safer. Their engagement and promotion of our safety system is essential for our success. While TCIR is our primary measure of performance, we continue to see improvements in our leading indicators. For instance, when we look at our total injuries, which include first-aid treatment cases, our injury frequency rate has improved 17% year-over-year. In addition, proactive activities such as reporting of near misses and safety stops have increased by 44%. The emphasis we have placed on improving our safety culture has resulted in a reduced severity of injuries, which is a direct result of our employees' involvement and engagement. We're confident that continued focus on ongoing investment in our safety systems will deliver our ultimate goal of a 0 injury workplace. Now let's turn to Slide 5 and a review of the second quarter performance. Our second quarter results demonstrate our ability to deliver consistent year-over-year earnings growth and drive backlog expansion while generating record performance at SAO. This past quarter marked our 12th consecutive quarter of year-over-year sales and earnings growth. It also marked the 12th consecutive quarter of year-over-year backlog growth, as we continue to execute at a high level. Our solutions help customers address critical performance requirements, and this is driving expanded sales opportunities and share gains across our end-use markets. At SAO, we are driving a richer product mix, which contributed to record second quarter operating income. This marked the second consecutive…

Thanks, Tony. Good morning, everyone. I'll start on Slide 9, the income statement summary. Net sales in the second quarter were $573 million, and sales, excluding surcharge, were $471.2 million. Sales, excluding surcharge, grew 5% year-over-year on 7% lower volume, driven by double-digit growth in our Aerospace and Defense and Medical end-use markets. Demand levels remain strong as total backlog grew 7% year-over-year, again, driven by the strength in Aerospace and Defense. This quarter marked the 12th consecutive quarter of year-over-year backlog growth. SG&A expenses were $55.3 million in the second quarter, up roughly $4 million from the same period a year ago. The increase was primarily due to the ongoing investments in additive manufacturing. Going forward, we expect SG&A expenses to be relatively flat or about $55 million per quarter for the balance of the year. Operating income was $55 million in the quarter compared to $55.4 million in the prior year period. Operating income in the current second quarter includes $2.3 million of restructuring charges related to our Amega West business as we took actions to rightsize the footprint and cost structure of that business to reflect current market conditions. Last year's second quarter included $1.2 million of acquisition-related costs associated with the LPW transaction. Excluding these special items, operating income was $57.3 million in the current quarter and $56.6 million in the same quarter last year. Operating income, excluding special items, as a percentage of sales, was 12.2% in the quarter. Our effective tax rate for the second quarter was 23.2%. We currently expect the effective tax rate to be 23% to 25% for the balance of the year. Net income for the quarter was $38.8 million or $0.79 per diluted share. When adjusted for the restructuring charges, adjusted earnings per share was $0.83 for the quarter.…

Thanks, Tim. Let's move to Slide 14. As I noted earlier, over half of our revenue comes from the Aerospace and Defense end-use market. The long-term fundamentals of the aerospace market are robust, and Carpenter Technology is well positioned to capitalize on the future growth, especially with the ramp-up of our facility in Athens, Alabama. But the 737 MAX issue is a reminder that disruptions in the complex aerospace supply chain will occur from time to time. At Carpenter Technology, we want to be well prepared to mitigate such disruptions as well as build out businesses that will accelerate our revenue and earnings growth. With that in mind, we continue to operate with a focus on driving near-term earnings growth, while also investing for the future in order to position Carpenter Technology for sustainable long-term growth. We are doing this in 3 distinct areas as portrayed on the slide. First, investing in emerging technologies, such as additive manufacturing to ensure our place as an irreplaceable solutions provider in the years to come. Second, identifying attractive market adjacencies for our solutions, such as soft magnetics that will strengthen our capabilities to capitalize on future disruptive trends. And third, expanding our capacity and capability to meet strong forward demand patterns in our Medical end-use market, which is one of our fastest-growing markets. Let me start with additive manufacturing. I firmly believe that the future of our industry and our customers' material needs are going to be meaningfully impacted by additive manufacturing. Our strategy over the last several years has been to build a leading end-to-end additive manufacturing platform by combining the foundation of our long history of powder metallurgy capabilities and expertise with capabilities acquired through several strategic acquisitions. The capstone of our additive manufacturing journey to date was the completion of…

[Operator Instructions]. The first question is from Josh Sullivan of The Benchmark company.

Are they willing to negotiate? How aggressive do you need to be to get them to take that capacity?

Josh, I think the point is here. We have orders from customers in different markets that today we cannot fit into our near-term schedule. So this isn't a point of us going out and trying to find "new business." This is a business that we have in front of us that now allows us to pull that forward and satisfy that customer.

And then customers are taking that inventory without any price concessions or anything along those lines?

We don't have any reason to do price concessions.

Got it. And then just as far as the VAP qualifications go, where do you stand on the total number expected? I know some are more important than others. Maybe where do you stand on a percentage basis of the total business needing VAP approvals?

With the four this quarter that puts us at '19. So I would say that's well over half of our way there. As you know, not every qualification is of equal weight. Obviously, the four that we received this quarter are meaningful, but there are still a couple large ones out there that we are working through. And in many times, I've said this before, I would take progress on a very substantial qualification before I might take a final qualification on another one, if that makes sense. So we received four qualifications this month, but just as importantly, we moved the ball down the field substantially on a couple other very significant ones for us. And I think you'll see it start to announce over the next couple of quarters.

Got it. And then just switching over to the PEP business. On the Medical side, obviously, some great growth. One, is there any opportunity to vertically integrate there? And then two, the utilization versus the margin dynamic with this new capacity coming on, how leverageable is that? How should we think about that as it gets filled here over the next year?

Let me take the second part first. We've timed this expansion in our Dynamet facility, primarily due to Medical and we're really on the razor's edge, so to speak. In many cases, you build capacity before the demand, we are actually both of those simultaneously. So our customers are asking for that material right now. It is a relatively complex expansion because we're expanding, not just both of our facilities, but we are moving some equipment between the facilities. So that makes just another level of complexity. So the answer there is, we are trying to expand and move equipment at the same time that we're trying to deal with at -- in some cases, significant increase in demand. That is the challenge right now. To be very transparent, I think the team is doing a very nice job, but I think we need to go faster and we have customers that are staying in beside us right now. But at the end of the day, they want more material. And we need to up our game a bit there to push this expansion across the line and get them the material they so much desire. That's the first part of your question of vertical integration. I think, that really might come from a -- I think that's where the additive manufacturing comes into play. I don't want to talk -- I don't have a lot of information I'd share with you at this time, but I think there are opportunities for us in the vertical integration side around the AEM business that we're building.

The next question is from Phil Gibbs of KeyBanc Capital Markets.

Tony, what was the backlog growth overall year-on-year? I think you said Aerospace and Defense is 14%, but what was the overall number? And then also, can you give us a feel for what your jet engine sales were year-end?

You got it. So the overall backlog growth was 7%. So it's a little lower than it's been in the last couple of quarters as you might guess, what's pushing that number down is energy business, the backlog has decreased substantially year-over-year and also our Transportation business was down a bit as well. That's a business for us that is quite critical for us, but at times, we have an issue of fitting that into the schedule. From an engine, I think you asked the engine sales year-over-year, they were up year-over-year by 17.5% and up 4% sequentially.

Okay. And then just a general kind of view here as we think about your Aerospace and Defense businesses and its entirety, you gave a nice breakout here between engines faster and structural and defense. But if I think about just overall aftermarket or call it, MRO versus OEM within that whole portfolio, any sense and -- or feel? Is it an equal split? Are you heavier on the OE side? Just trying to think through this as the market's going to be in flux for a few quarters?

It is not an equal split. I would say, we're more dependent on the OEM versus the aftermarket. I'd rather not give you the exact breakout, but I would say the majority is OEM.

[Operator Instructions]. The next question comes from Gautam Khanna of Cowen & Company.

A couple of questions. So just on the sequential EBIT impact that you talked about at SAO of $10 million, so flat sequentially. That's net. So what is sort of -- what's your estimate of the gross impact, if you will, before the mitigation? And what happens to the $4 million of out-of-phase surcharges? Does that ever come back? Is that included in the $10 million net? Any granularity there would be helpful.

Okay. I'll start with the first, and I'm going to let Tim take on your 2 different questions in two separate issues. We made a conscious decision, Gautam. I'm not surprised you are the one to ask this question. We made a conscious decision to say, it's not the best thing for us to do to talk about water content is per platform, right, which gets into your question about what's gross and what's net and trying to really bifurcate all of that, that out. Obviously, we have assumptions and we have marks for each one of those platforms to be able to get you to the number that we did. For us, we thought it was the best to give you that net number and really give you some clarity of what the impact was going to be for the quarter. We spent quite a bit of time on that, quite frankly. And I'd rather just stick to that going forward as opposed to saying what's the gross amount, what is the net amount. I think it is fair to point out that because of the longer cycle products that we make, the production cycle is quite long. Obviously, the impact in Q3 is going to be less because those products are already in production cycle. Our contracts, for the most part, allow us to not accept changes to that cycle, once it has been started. But then once we get to the second quarter -- sorry, the fourth quarter -- our fiscal fourth quarter, that dynamic changes a little bit, right? So the gross impact will increase. But as I said on the call, it also gives us an opportunity now to adjust mill schedules to go after some other business. So didn't answer your question directly there, but hopefully, you understand, that's really the way we've decided to guide on this very important issue going forward. And I'll give it back to Tim to talk about the lag.

Gautam, on the lag, I mean, as I said in my remarks, it generally hasn't been a big driver of profitability. One way or the other it's been about $1 million or $2 million. We did have that big spike in nickel prices early in the quarter. So assuming nickel prices normalize here and stay where they are, yes, there may be some return of that in a favorable lag, but that's kind of all built into our numbers for Q3.

And, Gautam, I'll just add, as you all know, you can do the math. I mean, $0.01 earnings per share is only about $600,000 of operating income for us. So it doesn't take a whole lot to get to a $0.01 a share in SAO came in a bit below our guidance, and that was really one of the main factors. The lag was a little bit more negative than what we anticipated, and our shipments were a little bit like those last couple of days of the quarter with the holidays. There's a couple of shipments that we didn't get out. That was really the main -- the 2 main drivers for a relatively small miss in SAO from our standpoint -- versus our guidance, I should say.

Yes. No, I agree. And then just so I understand, have the customers -- have your customers in the forging supply chain conveyed to you what their plans are for the June quarter? Or is this truly influx, like you just don't know, they haven't given you a number because we're hearing all kinds of things from the supply chain as they report. I'm just curious how fluid the situation is in? And then relatedly to a prior question on pricing in other markets, should we be concerned that as other suppliers like yourselves look to backfill capacity that's been freed up from a lower max volume that there is a bit of a price degradation as you pursue those marginal -- those other markets because everyone's trying to do it at the same time? Any perspective on both questions?

Listen, I'll take the second one first. We do not anticipate that, and we do not anticipate taking that approach. We see this as a long-term approach. This is a short-term issue, the way we see it, albeit a significant one. So it's not about price concessions in the near term. It doesn't make sense to us. That's not the business that we're in. And I think the relationships we have with our customers are very strong, and we understand that. And we want to have a long-term relationship with the customer. So I do not see that dynamic in the market. To your customer question, there's -- you can think about it this way. Our customers are in about every situation you can be in. Like we said, there are some that have been very -- much more, I'll say, aggressive looking forward, anticipating what this might be, and they've made some adjustments to their requirement, and those are built in. Those are built into our guidance today. There are others that, although, they're making these adjustments, they've pivoted a bit and said, "Hey, we have a need over here. Can we move some of our core capacity to that area. We still see some urgent spot request. There are other customers got them that are still working through this and understanding how they want to handle it. I've listened to a couple of earnings calls prior to ours and listen to the management team speak, and it's a very important point that you said, you can't turn this capacity on and off like a light switch. So a lot of them are really trying to think, "Hey, I can't take this production down to zero, because if I do, I can't get it back fast enough when this demand comes back. So there's a nice chunk of customers that are wrestling with that very difficult question right now. And, of course, there's a couple that have built a little bit more inventory than what they would like, and we're working with them on an individual basis to mitigate that for them. I can't say that majority of our contracts do have some flexibility clauses that we -- that -- and it -- that it defines when a customer can and can't make a change. For the most part, we do not accept changes once that, that product has started production or if it's in finished goods. But again, we prefer a long-term relationship, and we work with each of our customers on a one-on-one basis to try to help them manage through this process effectively just like we're trying to.

And one last one, if I may. Just at the PEP segment, Boeing announced the 787 rate cut to 10 at some point in early 2021. When would you, A, like, is there any ballpark you can give us on the magnitude of the impact to PEP Dynamet? And when you might feel it? Because I know it's a big titanium fastener platform and wondering when that starts to kick in and how that informs your view on the June quarter?

We've taken into consideration. So the guidance that we have given you takes into consideration all those factors. Now I've not given a specific number of what the -- how that impacts us for the 787. I would say this when you think about Dynamet. And a lot of people rightly so think about Dynamet as an aerospace business, and that's true. But the -- and it's a very good business for us, and we're very appreciative to have it. But Dynamet is a Medical business as well. And over 50% of our revenues are coming from Medical and Dynamet. And that's a bit of a mind shift that not everyone has really caught out to yet. So I hope that helps.

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

Thanks, Kate, and thanks, everyone, for joining us today on our second quarter earnings call. We look forward to speaking with all of you on our third quarter call in April. Have a great day.

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