Carpenter Technology Corp

NYSE:CRS

Earnings Call Transcript 2023-Q1

[Operator]

Good morning, and welcome to the Carpenter Technology Corporation's First Quarter Fiscal 2023 Conference Call. [Operator Instructions]

Please note this event is being recorded today. I would now like to turn the conference over to Brad Edwards, Investor Relations. Please go ahead.

[Brad Edwards]

Thank you, operator. Good morning, everyone, and welcome to the Carpenter Technology Earnings Conference Call for the fiscal 2023 first quarter ended September 30, 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 the exhibits attached to that filing.

Please also note that in the following discussion, unless otherwise noted, when the 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.

[Tony Thene, executive]

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. For our first quarter of fiscal year 2023, our total case incident rate was 1.7%. While this is less than half of the metal manufacturing industry average rate, this performance is not up to the standards to which we hold ourselves.

Fortunately, despite the increase in rate, the severity of injuries continues to decline. The rate increase is largely due to the increased 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. Further, we continue to drive our stop program, which enables employees to stop work whenever there is a potential issue or concern.

Our ultimate goal continues to be a 0 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 first quarter. Although the strong demand environment across our end-use markets, we continue to realize price gains and contract negotiations and see our backlogs increase. Notably, our backlog increased 10% sequentially and 155% year-over-year. This marks the seventh consecutive quarter of backlog growth.

In order to satisfy this aggressive demand, we are focused on increasing productivity across our operations and we are working closely with our customers as most are requesting additional volume with accelerated delivery dates. For the quarter, the SAO segment performed at the upper end of our expectations, driven by the growing market demand and continued operational improvements. PEP seller was on pace to meet our expectations until Hurricane Ian delayed shipments for our Dynamet facility in Florida at the end of the quarter. Fortunately, no employees were injured, and we were able to return safely to full operations shortly after the required evacuation orders were lifted.

Finally, our liquidity remains healthy. We finished the quarter with $351 million in total liquidity. Now let's move to Slide 6 in the end-use market update. Most of our end-use markets were up year-over-year, reflecting a strong demand environment and the ongoing recovery. And as you will hear throughout my comments, our near-term and long-term outlook for each of the end-use markets remains positive.

Sequentially, however, we were denied across most of our end-use markets with the exception of Aerospace and Defense. The primary factor was the sharp ramp in aerospace pushing out production of material and other end-use markets. In addition, Hurricane Ian delayed shipments from our Dynamet facility in Florida.

Now let's review each of the end-use markets. Our Aerospace and Defense end-use market sales were up 3% sequentially and 36% year-over-year. Global aerospace traffic continues its recovery, driving up expected build rates. As customers across each of the aerospace submarkets work to meet build rates, demand for our materials is accelerating.

The defense submarket is down sequentially, primarily driven by the combination of uncertain government budget horizon and extended lead times. We see this as a short-term issue as there is continued interest in our advanced alloys for the next-generation platforms.

Excluding defense, aerospace sales were up 7% sequentially and 40% year-over-year. More specifically, sales in the aero engine submarket were up 24% sequentially and up 45% 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 11% sequentially and 190% year-over-year. Notably, the backlog value now stands at nearly 2x pre-pandemic levels, reflecting price increases and customer urgency to secure material.

In the medical end-use market, sales were down 7% sequentially and up 34% compared to last year. The year-over-year results reflect ongoing recovery in elective surgeries with hospital staffing levels improving. 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 to pre-pandemic levels by the end of calendar year 2022. We are seeing replenishment in the supply chain to support the expected growth as our medical end-use market backlog is up 13% sequentially and 211% in year-over-year. In the transportation end-use market, sales were down 28% sequentially and down 25% compared to last year. Light-duty vehicle demand remains high with consumers continuing to buy even as inventories are at historic lows.

With strong demand and low inventories, build rates are expected to increase throughout calendar year 2023. In the Energy end-use market, sales were down 13% sequentially and up 13% compared to last year.

In the Oil and Gas submarket, demand continues to outpace supply, driving growth and capital investment. The supply shortage has been further challenged by recent geopolitical disruptions.

In addition, we see growing demand for advanced premium alloy solutions for drilling activities in harsh environments. In the industrial and consumer end-use market, sales were down 17% sequentially and up 3% year-over-year. We continue to see healthy demand in the electronics submarket, largely driven by customer engagement for materials from our hot strip mill in Reading, which was commissioned just over a year ago.

Now I will turn it over to Tim for the financial summary.

[Timothy Lain, executive]

Thanks, Tony. Good morning, everyone. I'll start on Slide 8, the income statement summary. Net sales in the first quarter were $522.9 million, and sales, excluding surcharge, totaled $375.7 million. Sales excluding surcharge increased 20% from the same period a year ago on 3% higher volume. Sequentially, sales were down 7% on 13% lower volumes. Gross profit was $54.8 million in the current quarter compared to $25.2 million in the same quarter of last year and $72 million in the fourth quarter of fiscal year 2022.

As we pointed out on last quarter's call, the fourth quarter of fiscal year 2022 gross profit results included a benefit of $11.9 million related to employee retention credits that were recorded and called out as a special item during that quarter.

Sequentially, adjusting for the roughly $12 million of nonrecurring benefits, gross profit is down slightly due to the lower sales from Q4 to Q1.

The significant improvement in gross profit year-over-year is primarily driven by the higher sales and improving product mix and increased selling prices to offset inflationary cost increases.

SG&A expenses were $46.5 million in the first quarter, up about $2 million from the same period a year ago. When adjusting for the special items that we called out in the fourth quarter of fiscal year 2022, SG&A expenses were up roughly $1 million sequentially.

Note that the SG&A line includes corporate costs, which totaled $17.1 million in the recent first quarter. The reported corporate costs increased about $3 million from the same quarter last year and about $4 million sequentially when considering the special items included in the fourth quarter.

As we look ahead to the balance of fiscal year 2023, we continue to expect corporate cost to run between $18 million to $20 million per quarter. Operating income was $8.3 million in the current quarter. When excluding the impact of special items in prior quarters, adjusted operating loss was $17.5 million in the same quarter last year and adjusted operating income was $14.9 million in our recent fourth quarter.

Our effective tax rate for the first quarter was 11.5%. The first quarter rate is lower than the statutory rate, largely due to the outsized impact that certain nontaxable earnings and permanent items have on the rate given our pretax loss in the recent quarter.

As pretax levels increased throughout the fiscal year, we expect that the full year effective tax rate will be approximately 22% to 24% for the full fiscal year 2023, but we'll continue to have variability on a quarterly basis. Earnings per share for the quarter was a loss of $0.14 per share.

Now turning to Slide 9 and our SAO segment results. Net sales for the first quarter were $447.3 million or $305.7 million excluding surcharge. Compared to the same period last year, net sales, excluding surcharge, increased 18% on 4% higher volumes. Sequentially, sales decreased 7% on 14% lower volumes.

The year-over-year improvement in net sales was driven by increased volume as well as an improving product mix across most of our key end-use markets, as Tony reviewed on the market slide.

Moving to operating results. SEO reported operating income of $19.9 million in our recent first quarter. The same quarter a year ago, SAO's adjusted operating loss was $4.6 million and in the fourth quarter of fiscal year 2022, SAO reported adjusted operating income of $20 million.

The $24.5 million improvement in adjusted operating performance on a year-over-year basis was largely due to higher sales coupled with an improving mix and increased selling prices.

Looking ahead, our backlog remains strong and grew sequentially again this quarter as order rates across all of our key end-use markets remain strong. As we've highlighted, we continue to see increased activity across 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 $30 million to $32 million in the upcoming second quarter of fiscal year 2023.

Now turning to Slide 10 in our PEP segment results. Net sales in the first quarter of fiscal year 2023 were $93.2 million, were $87.7 million, excluding surcharge. Net sales, excluding surcharge, increased 19% from the same quarter last year and were down 6% sequentially.

The year-over-year growth in net sales reflects increased demand across all business units. 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 significant improvement in year-over-year sales in our additive and distribution businesses. The sequential decrease in net sales was influenced by the impact of missed shipments from our Dynamet Florida facility as a result of the hurricane in late September.

In the current quarter, PEP reported operating income of $6.3 million. This compares to adjusted operating income of $0.9 million in the same quarter a year ago and adjusted operating income of $8.2 million in the fourth quarter of fiscal year 2022.

The operating income improvement year-over-year is primarily the result of increased net sales across each of the business units, driven by the ongoing improving market demand conditions. Sequentially, operating income was down slightly due again primarily to the hurricane impact on shipments for the quarter.

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 $8 million to $10 million for the upcoming second quarter.

Now turning to Slide 11 and a review of free cash flow. In the current quarter, we used $78 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 $121 million. The increased inventory is the result of ramping up production activities to satisfy the growing demand, namely the targeted shipments for the second half of fiscal year 2023.

We continue to actively manage our supply chain to minimize potential disruptions. We maintain regular contact with key suppliers to ensure we have a steady supply of our critical raw materials and other operating supplies for the foreseeable future.

In the first quarter of fiscal year 2023, we spent $13 million on capital expenditures. We continue to target about $100 million of capital expenditures for fiscal year 2023. I will also highlight we continue to fund a constant dividend to our shareholders, which we consider as part of our free cash flow.

With those details in mind, we used $101 million of free cash flow in the first quarter of fiscal year 2023. Our liquidity remains healthy and we ended the current quarter with total liquidity of $351 million, including $53 million of cash and $298 million of available borrowings under our credit facility.

With that, I'll turn the call back to Tony.

[Tony Thene, executive]

Thanks, Tim. Now to recap our first quarter of fiscal year 2023. We are well positioned to achieve our target of delivering operating income at the fiscal year 2019 run rate by the fourth quarter of fiscal year 2023. We are operating in a strong demand environment with a positive outlook in each of our end-use markets. Notably, the aerospace and medical markets 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 continue to ramp our operations with an ongoing focus on maximizing throughput and productivity in key flow paths. Through our raw material surcharge mechanism and our ability to increase prices on our contractual and transactional business, we have been able to mitigate a large percentage of the recent inflationary pressures.

We continue to work closely with key customers, navigating the recovery in supply chain challenges and partnering to solve their critical needs. As a result of these efforts, we believe we will continue to maintain a healthy liquidity position.

Now let's take a closer look at our full fiscal year 2023 outlook. Last quarter, I spoke about a projection by the fourth quarter of fiscal year 2023, we could achieve an operating income run rate equal to our fiscal year 2019 performance. To be specific, this means that we expect to reach quarterly operating income of at least $60 million by the fourth quarter of fiscal year 2023.

Our current view of productivity, throughput, inflation, supply chain constraints and labor availability are built into this projection. I will spend a few minutes now to provide more detail on how we plan to get there. First, we project sales excluding surcharge to grow at a 13% to 15% compound growth rate over the next 3 quarters.

As mentioned in previous slides, we have a strong outlook across each of our end-use markets for both near-term and long-term growth. Despite concerns of a potential recession, our materials are required in industries where demand exceeds supply. We see these dynamics in aerospace, medical, energy and light-duty vehicle industries, among others.

The strength of the demand for our materials is confirmed by the continued growth in our backlog. Backlogs are up 10% sequentially and 155% year-over-year. Second, with the increase in revenue and associated volumes, we will realize improved margins. And while inflationary pressures have increased our cost, price increases on both transactional and contract businesses over the last 12 months will help offset those pressures.

In particular, the SAO segment will have a meaningful improvement in operating margins. With the return to pre-pandemic sales, we expect to approach pre-pandemic operating margins in the SAO segment.

Finally, we have positioned ourselves operationally to capture the growth and realize our goals as we continue to focus on improving our productivity across facilities. And as noted earlier, we built some inventory in the first quarter to make sure we have the necessary resources to achieve our goal.

The bottom line is that corporate technology is poised to return to pre-pandemic levels and significantly increased earnings over the longer term due to the strong markets we participate in, our innovative solutions, solid customer relationships and our growth opportunities.

Thank you for your time. And now I will turn it over to the operator to take your questions.

[Operator]

[Operator Instructions] And our first question here will come from Gautam Khanna with Cowen.

All right. We will take our next question from Michael Leshock with KeyBanc Capital Markets.

[Michael Leshock, analyst]

I wanted to ask on scrap availability. It seems like that's improving. And do you see that as an enabler to margin upside as the year progresses within SAO?

[Tony Thene, executive]

Well, it's a good question, and that's something that is -- can be cyclical as far as availability. Right now, that's not an issue for us, and we're being selective about what we do out in the market. So not an issue for us right now. And as you well know, scrap usage is a very high percentage for us in our process.

[Michael Leshock, analyst]

And then just looking at the guidance you gave for the balance of the year, what kind of contribution are we seeing from soft mag? And is there any view on just what we should be thinking within that business?

[Tony Thene, executive]

Soft mag is material over the next couple of quarters. In fact, we just -- we're finalizing a very attractive contract for us with a major customer, at very nice margins, good contract for both of us. So over the next couple of quarters, it will be material. And then as you get into FY '24 and beyond becomes even a bigger part of our business.

[Michael Leshock, analyst]

And then just lastly for me on inventory levels here, you talked about the increase quarter-over-quarter to kind of meet the ramp needs. Are you comfortable with the levels here? Or as the ramp progresses, do you see the need to increase further?

[Tony Thene, executive]

We'll build inventory again in the second quarter. By the end of the year, our plan is to flush that out. So you'll probably be about the same year-over-year. You're in -- what I'm saying is you're in FY '23 about the same place you were in FY '22. But right now, when you've got a market situation like we have where the demand is significantly above the supply levels, we're trying to do all we can to maximize our output. And what that means right now is building some of that inventory because our production rates across key centers aren't 100% aligned. So we'll build that inventory when we get the chance for the most part in the upstream and be able to ship that out to our customers in the second part of the year.

[Operator]

[Operator Instructions] Our next question here will come from Josh Sullivan from the Benchmark Company.

[Joshua Sullivan, analyst]

The dynamic you mentioned in the prepared remarks where end markets outside of aerospace were dislocated by the strong aerospace demand. Just given aerospace is going to be growing, but it's a more complex purified product, is there any timing gap where it takes more time to manufacture the aerospace grade materials to the various furnaces in the lower grade materials they're replacing?

[Tony Thene, executive]

Yes. I alluded to that, that at times based on the products we're running that the aerospace materials could have a longer production cycle. Again, I want to make sure I'm clear on this. I think this is short term. We're always moving our production schedules around, but in the first quarter, that was a bit more extreme as we're trying to meet the demand from our aerospace customers. I think over the next couple of quarters, that will even out a little bit.

[Joshua Sullivan, analyst]

Got it. And I know it's hard to measure aerospace aftermarket demand. But if you look at the number of engines delivered by Pratt, GE, Rolls, or OEMs versus the material delivered by Carpenter, does it suggest aftermarket needs are accelerating faster than passenger traffic? Or do you think OEMs are stocking inventory, just a pet production risk given some of the issues with the broader and better supply chain?

[Tony Thene, executive]

When we talk to customers, every one of them say they don't have enough inventory right now, and they all want it faster than what the current lead times are. So I don't see a mismatch there. And I think maybe, Josh, it's a good time. That question kind of leads to a bigger piece. And I think it's really important to note that from an aerospace standpoint, or really for an overall market standpoint, there's not a market demand problem. In fact. Our demand is there. It's strong, it's accelerating. And you always hear this news like you mentioned about aftermarket inventory levels build rates for the airplane framers, whether they're decreasing or pushing out. And I can tell you the bottom line that now that's going to have a negative impact for the rest of this fiscal year and into the next year and beyond.

And the main issue is that right now, demand significantly outpaces current supply. And that's not going to change anytime soon. So it's why we're very confident in our fourth quarter target and then saying we're going to double that by FY '26. I mean those types of items or news items in the industry is just not going to change because we have more than enough demand right now.

[Joshua Sullivan, analyst]

Got it. Got it. And then in the Russian titanium supply chain realignment, just can you quantify all the moves this quarter?

[Tony Thene, executive]

Josh, I didn't hear the last piece of that.

[Joshua Sullivan, analyst]

Russian titanium supply chain realignment. Did Carpenter see any meaningful new relationships as a result of that?

[Tony Thene, executive]

Yes. I think it's a good -- that's come up a couple of times, and maybe I can give you just a couple of pieces where we would play and may well make it more clear for everyone. In aerospace, of course, the U.S. entities that provide the large titanium forgings, they could pick up some share because of this. And in turn, we could participate via conversion services that we have for those companies.

On the medical side, we compete with the VSMPO on the -- through Dynamet. And there are some points there where we're working with customers where they're assessing their risk, still making some sourcing decisions there.

In terms of how this stacks up for Carpenter Technology, it's really not going to be a major game changer compared to what we have going for us in this massive demand on aerospace, medical, electrification. So there will be some opportunities for us, but not as big, maybe as for some of the companies that actually melt titanium. As you know, we're not a melter of titanium. So hopefully, that gives you a little bit more insight to what we do in that area.

[Operator]

Our next question will come from Phil Gibbs with KeyBanc Capital Markets.

[Philip Gibbs, analyst]

Question was just on net working capital. You mentioned the seasonality of the build. And obviously, you've got very strong volume aspirations as the year progresses. How should we think about net working capital this quarter and then over the balance of the year?

[Tony Thene, executive]

Yes. I'll let Tim take that one.

[Timothy Lain, executive]

Yes, Phil. Tony covered the detail on inventory. I mean that's obviously our biggest component. The rest will follow. Your payables will follow inventory to a certain extent. It's all based on timing. And then receivables, obviously, a sales ramp, assuming that we maintain a relatively consistent DSO. We should see some increase in AR as sales ramp and the last -- the rest of the net working capital should be fairly in line to those movements.

[Philip Gibbs, analyst]

Okay. And then regarding aerospace specifically, are you guys seeing any material differentiation between engine and nonengine, which for you, I know include structural and landing gear avionics and whatnot? Is there a difference between where the poles are stronger?

[Tony Thene, executive]

Well, Phil, this is Tony. I mean all of our submarkets across aerospace are strong right now. There could be a quarter that you see a little dip maybe in distribution or one of the smaller ones, but when it comes to engines and even more so now fasteners, that demand is extremely strong. And again, every one of our customers are asking for more and sooner. There is no deviation from that. It is -- we need more, and we need it sooner. And that's across all of our aero submarkets.

[Philip Gibbs, analyst]

And then last question for me, and I appreciate it is just on labor and labor productivity. Obviously, a big talking point for the OEs and the suppliers alike. Where do you all find you are on that labor on productivity curve? Do you need more headcount and/or where do you think you are on the productivity curve as the cycle progresses?

[Tony Thene, executive]

Yes, it's a good question, Phil. Thanks for asking that. Across our locations, there's still a couple of locations where we're still actively hiring usually because we're bringing on another line or we know that we've got demand coming in the future for our larger locations. We're in pretty good shape as far as the number. The real key for us is on the training piece because during the last couple of years, as you stated, we've had -- the industry has had a pretty good turnover of the workforce, whether that be through retirements or other actions. And we need to train that workforce.

As you know, we have a very complex, complicated manufacturing system. We have never failed products. We have to maintain that quality. So from a rate standpoint, we're running full, but we're not running at the rates that we ran in 2019. And that's why you see it's coming up over the next couple of quarters.

We need to do that in a very structured, a very planned process to make sure all of our employees are trained properly and they can operate that equipment at the very highest quality standards.

[Operator]

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

[Brad Edwards]

Thanks, Joe. Thanks, everyone, for joining us today for our fiscal first quarter 2023 earnings call. We appreciate you spending the time and have a great rest of your day. Take care.

[Operator]

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